Working Paper: CEPR ID: DP17845
Authors: Dirk Hackbarth; Dongming Sun
Abstract: We consider the behavior of leverage ratios in a trade-off model with investment. Debt underutilization to retain financial flexibility persists even when firms exercise their last investment options, and it is more (less) severe for more back-loaded (front-loaded) investment opportunities. Leverage paths crucially hinge upon the structure of the investment process, which leads firms to have significantly different target leverage ratios. Structural estimation of key parameters reveals that simulated model moments can match data moments. In simulated panels, leverage regression results are in line with the empirical evidence, and average leverage ratios are path-dependent and persistent for extended periods of time.
Keywords: Capital Structure; Investment Policy; Financial Flexibility; Real Options
JEL Codes: G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial flexibility (G32) | underutilization of debt (G32) |
| backloaded investment opportunities (G11) | underutilization of debt (G32) |
| investment structure (G31) | variation in target leverage ratios (G32) |
| growing assets-in-place (D25) | different leverage dynamics (C69) |
| optimizing behavior (L21) | low or zero leverage firms (G32) |
| lack of dynamic financing-investment interactions (G19) | overestimation of target leverage ratios (G32) |
| investment process (G11) | leverage dynamics (C69) |