On the Role of External Financing Costs in Optimal Investment Decisions

This paper brings into focus a link between the investment and nancing decisions of a rm which has an access to costly debt nancing. Our analysis shows that lump-sum debt issuance costs play a prominent role in a determination of the optimal investment strategy. Faced with larger lump-sum debt issuance costs, a rm will optimally set up a higher-scale investment project in order to "compensate" deadweight nancing costs by higher return. Moreover, in the presence of lump-sum debt issuance costs, the optimal investment scale of nancially constrained rms exhibits an inverted U-shaped relationship with the rm's borrowing capacity, so that relatively more/less constrained rms will realize smaller investment projects, whereas rms with an intermediate borrowing capacity will undertake larger investment.