Dynamic Investment, Capital Structure, and Debt Overhang

We model dynamic investment, financing and default decisions of a firm, which begins its life with a collection of growth options. The firm exercises them optimally over time, and finances the costs of investment by adjusting its capital structure, which trades off the tax benefits with the distress cost of debt and the agency cost of investment distortions from potential debt overhang. Conflicts of interests between equityholders and various classes of debtholders are managed through optimal choice of investment triggers, capital structure, and default triggers. We show that (i) existing debt may significantly distort investment decisions (debt overhang and risk shifting); (ii) anticipating distortions induced by debt, firms with more growth options on average have lower leverages, consistent with empirical evidence; (iii) the priority structure of debt has significant effects on the firm’s default, leverage, and investment decisions, when existing debt is exogenously given; (iv) when the future growth options are perfectly anticipated, the firm optimally chooses its initial investment, default triggers and capital structure decisions, so as to mitigate the anticipated endogenous debt overhang. In this case, financial contracting plays a less prominent role.