Corporate Investment and Financing Dynamics∗

This paper studies the behavior of leverage ratios in a dynamic trade-off model with real frictions. Firms underutilize debt when financing investment to retain financial flexibility. Underutilization of debt persists even when firms exercise their last investment options, and it is more (less) severe for more back-loaded (front-loaded) investment opportunities. Thus, leverage dynamics crucially hinge upon the structure of the investment process and otherwise identical firms appear to have significantly different target leverage ratios. Structural estimation of key parameters reveals that simulated model moments can match data moments. We obtain capital structure regression results in line with the empirical evidence, and explain the empirical puzzle that average leverage ratios are path-dependent and persistent for extended periods of time. JEL Classification Numbers: G31, G32.