Journal Article

Dynamic Investment, Capital Structure, and Debt Overhang

Suresh Sundaresan, Neng Wang and Jinqiang Yang

in The Review of Corporate Finance Studies

Volume 4, issue 1, pages 1-42
Published in print March 2015 | ISSN: 2046-9128
Published online December 2014 | e-ISSN: 2046-9136 | DOI: https://dx.doi.org/10.1093/rcfs/cfu013
Dynamic Investment, Capital Structure, and Debt Overhang

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  • Macroeconomics: Consumption, Saving, Production, Employment, and Investment
  • Economics
  • Corporate Governance

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We develop a dynamic contingent-claim framework to model S. Myers’s idea that a firm is a collection of growth options and assets in place. The firm’s composition between assets in place and growth options evolves endogenously with its investment opportunity set and its financing of growth options, as well as its dynamic leverage and default decisions. The firm trades off tax benefits with the potential financial distress and endogenous debt-overhang costs over its life cycle. Unlike the standard capital structure models of Leland, our model shows that financing and anticipated endogenous default decisions have significant implications of firms’ growth-option exercising decisions and leverage policies. The firm’s ability to use risky debt to borrow against its assets in place and growth options substantially influences its investment strategies and its value. Quantitatively, we find that the firm consistently chooses conservative leverage in line with empirical evidence in order to mitigate the debt-overhang effect on the exercising decisions for future growth options. Finally, we find that debt seniority and debt priority structures have both conceptually important and quantitatively significant implications on growth-option exercising and leverage decisions as different debt structures have very different debt-overhang implications.

Keywords: E2; G1; G3

Journal Article.  21040 words.  Illustrated.

Subjects: Macroeconomics: Consumption, Saving, Production, Employment, and Investment ; Economics ; Corporate Governance

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