ARTICLE IN PRESS

Journal of Financial Economics 89 (2008) 232–252

Volume 88, Issue 1, April 2008

ISSN 0304-405X

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OF BUSINESS ADMINISTRATION,
UNIVERSITY OF ROCHESTER

Can real options explain financing behavior?$

Yuri Tserlukevich 
Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong

a r t i c l e i n f o abstract

Article history: Trade-off models commonly invoke financial transaction costs in order to explain
Received 2 July 2007 observed leverage fluctuations. This paper offers an alternative explanation based on
Received in revised form real options. The model is frictionless on the financing side but incorporates
16 October 2007
irreversibility and fixed costs of investment. Results obtained from simulating the
Accepted 16 November 2007
Available online 5 July 2008
model are broadly consistent with observed financing patterns. Market leverage ratios
are negatively related to profitability, mean-reverting, and depend on past stock returns.
JEL classification: The gradual and lumpy leverage adjustments can occur in the absence of financial
G31 transaction costs. This evidence shows that incorporating real frictions into structural
G32
models increases their explanatory power.
& 2008 Elsevier B.V. All rights reserved.
Keywords:
Capital structure
Real options
Corporate tax

1. Introduction them to incur costs such as underwriting fees on new debt

Since Modigliani and Miller (MM hereafter) (1958)
published their financial irrelevance result, theorists have
focused on violations of the MM assumptions to under-
stand corporate financing choices. Motivated by this
literature, empiricists have looked to taxes and financing
frictions for an explanation of observed financing beha-
vior. For example, it is commonly argued that significant
transaction costs are responsible for wide fluctuations in
leverage ratios over time. This is because firms will adjust
financing variables infrequently if these adjustments force
$ tion costs cannot explain investment behavior. In
I have benefited from excellent comments of the seminar partici-
pants at Lehman Brothers, London Business School, Wharton, Notre
Dame University, University of Toronto, Emory University, HKUST, Hong
Kong University, National University of Singapore, Melbourne Business
School, York University, NHH Bergen, Stockholm School of Economics,
Universitat Pompeu Fabra, and SAFE conference in Verona. I am
especially grateful to Christopher Hennessy, Viral Acharya, Alan
Auerbach, Jonathan Berk, Andrea Gamba, Hayne Leland, Erwan Morellec,
and Ilya Strebulaev.
 Tel.: +852 2358 8016.
E-mail address: yuri@ust.hk
flotations.
In this paper, I show that there is no need to appeal to
large financing frictions to explain observed financing
patterns. Real frictions, that are usually invoked to explain
the investment behavior, present a much simpler expla-
nation. It has long been noted that theories of investment
without real frictions, e.g., Tobin’s (1969) Q-theory, cannot
explain investment behavior (see Hayashi, 1982; Abel and
Eberly, 1994; Cooper and Haltiwanger, 2006).1 I argue that
real frictions are also essential for explaining financing
behavior. The attractive feature of my model is that it can
contribute to explaining both financing and real invest-
ment decisions. In contrast, theories relying on transac-
particular, theories relying exclusively upon transaction
1
Early attempts to remedy the weakness of Q-theory focused on the
convex costs of adjusting the capital stock, e.g., Hayashi (1982). In a more
general approach, Abel and Eberly (1994) introduce wedges between the
buy and sell prices of capital and/or fixed costs of adjustment. The recent
empirical work by Cooper and Haltiwanger (2006) shows that real
frictions, such as described in Abel and Eberly (1994), are essential to
replicate observed investment patterns.

0304-405X/$ - see front matter & 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jfineco.2007.11.003
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252
Nomenclature
Xt product demand shock
K installed capital
a elasticity of demand
m drift of the demand shock
sm market volatility
si demand shock idiosyncratic volatility
s demand shock total volatility
b market sensitivity ‘‘beta’’
tc corporate tax rate
ti tax rate on interest at individual level
r pre-tax rate of return on risk free asset
f flotation cost as percentage of bond value
P proportional investment cost
costs cannot explain why surges in financing activity tend
to be correlated with surges in real investment and why
technology has a profound effect on leverage.
To illustrate the main argument, I develop a dynamic
model of optimal financial structure in the presence of
real frictions. The model is parsimonious on the financial
side, featuring: zero transaction costs, a convex corporate
income tax, and a linear tax on interest income. That is,
the model features a single violation of the MM assump-
tions: there is a tax advantage to debt. Setting transaction
costs to zero helps to illustrate the main argument in this
paper. However, I acknowledge the limitations of this
assumption. For example, the model cannot explain why
firms engage in infrequent rebalancing policies or go
bankrupt.
The main argument relies on two real-world con-
siderations in addition to the existence of real options.
First, Graham (2000) shows that loss limitations in the tax
code cause the expected marginal corporate tax rate to
increase with taxable income. For a healthy company,
there is a tax advantage to debt. However, when taxable
income is sufficiently low, there is a tax disadvantage to
debt, as the tax rate on interest income at the individual
level exceeds the expected marginal corporate rate. The
second important consideration is that only installed
capital (assets in place) generates taxable revenue for the
firm. Future growth options increase the value of equity
but do not yet generate taxable revenues.
With these facts in mind, consider a firm that
experiences a positive demand shock. Real frictions, such
as a wedge between the buy and sell cost of capital, cause
the firm to delay installing additional capital. Conse-
quently, the value of growth options increases at a faster
rate than taxable revenues. Under the optimal tax
planning strategy, the firm increases debt service in
proportion to increases in taxable revenues. Hence, debt
value increases more slowly than equity value. That is,
while the firm is in the region of ‘‘optimal investment
inaction,’’ the market leverage ratio falls in response to
positive demand shocks. Note that transaction costs are
not necessary to produce this effect.
233
F fixed cost parameter
I interest payment
VðX t Þ value of assets in place
DðX t Þ value of debt
SðX t Þ value of equity
AðX t Þ total value of the firm
GOðX t Þ value of the growth options
AðX t Þ total value of assets
xðKÞ investment barrier
b constant, solution to quadratic equation
B valuation constant determined by the bound-
ary conditions
g scaling constant
p profitability
Despite its parsimony, the model is able to replicate a
broad set of empirical facts. First, I show that the model
replicates the empirically observed inverse relation be-
tween profitability and leverage. This effect is commonly
attributed to firms delaying action due to reluctance to
incur financial transaction costs. In my model, the market
leverage ratio falls with positive demand shocks due to
increases in the value of growth options. The relation
reverses when growth options are finally exercised.
However, the infrequent lumpy investment in the cross
section of firms simulated from the model causes the first
effect to dominate.
Second, the simulated firms exhibit mean-reverting
leverage ratios, which is also consistent with empirical
observation. Mean reversion reflects the investment cycle
of the firm. Intuitively, leverage ratios decline when the
firm is in the investment inertia region. Low-leverage
firms have valuable growth options and are likely to invest
in the near future. However, they do not reflexively add
more debt simply because their equity value is relatively
high. The leverage ratio only spikes upwards when the
firm exploits its growth options. The reason is simple. It is
only optimal to increase debt once new productive
capacity comes online and starts generating taxable
revenues. In contrast, equity value increases continuously
in the underlying state variable—reflecting the capitalized
value of future growth options. This increase in equity
value is not met with a proportional increase in debt
within the inertia region. The leverage ratio only reverts to
the mean at the time the real option is exploited.
Third, I find that, consistent with empirical observa-
tion, the market leverage ratio depends on the path of past
stock returns. For example, a firm that experiences a run-
up in stock price followed by a decline is predicted to have
a high leverage ratio. This is because the firm operates
with excess capacity that cannot be shed. For such a ‘‘cash
cow’’ firm, debt value is high because taxable revenues are
high. At the same time, the value of growth options is low
since the firm is far away from the endogenous invest-
ment threshold. The result is that firms in sectors where
the state variable (demand) has declined significantly
 ARTICLE IN PRESS
234 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252
relative to historic highs are predicted to have high
leverage ratios. This leads to a path-dependent leverage
ratio.
Finally, aside from shedding light on empirical ob-
servation, the model also casts doubt on a popular ‘‘folk
theorem’’ of corporate finance. Based upon MM (1963), it
is commonly argued that, in a world where the only
financial friction is a tax advantage of debt, the optimal
financial structure entails 100% debt finance. In my model,
the tax advantage accorded to debt is the only financing
friction. However, the optimal market leverage ratio
generally falls between 43% and 73%. The intuition is
based on the following observation. Debt is proportional
to current revenues from assets in place, while equity
value incorporates expectations regarding growth in
revenues from assets in place. Therefore the leverage
ratio decreases with expected growth.2
The primary contribution of my paper is to illustrate
the necessity of incorporating real investment decisions
and real frictions into dynamic structural models of
corporate financial decisions. As such, the model cannot
explain the number of stylized facts attributed to
transaction costs. For example, issuing debt at the risk-
free rate, the necessary consequence of the frictionless
rebalancing assumption, contradicts the observed high
interest spreads. Therefore I investigate separately
whether combining financing and real frictions can
provide a better fit to the data. As I show in the extension
of the model, the effects of real frictions on leverage are
complementary to the effect of financing frictions. As an
example, consider a firm that is experiencing an increase
in profitability. Financing frictions prevent the firm from
adjusting leverage in response to higher profits. At the
same time, real frictions ensure that the value of the firm’s
unexercised options increases. As a result, the leverage
ratio exhibits a large decline with profitability. Obtaining
this result does not require imposing unrealistically large
frictions on either the financing side or the real side.
The paper builds on extensive literature on dynamic
capital structure. Fischer, Heinkel, and Zechner (1989) and
Goldstein, Ju, and Leland (2001) develop tractable multi-
period models incorporating dynamic debt restructuring.
However, neither model incorporates real investment
decisions. Leary and Roberts (2005) and Strebulaev
(2007) show that the model of Fisher et al. can be
reconciled with observed financing patterns under a
suitable parameterization of transaction costs. Kurshev
and Strebulaev (2006) explain the size-leverage puzzle by
modeling and solving the case with fixed adjustment
costs. Two related papers by Hennessy and Whited (2005,
2007) assume that investment is reversible and use
dynamic programming to analyze a broad variety of
capital structure effects. All of these models share reliance
upon financial transaction costs. My paper offers an
alternative approach.
2 3
This effect has been noted by Berens and Cuny (1995) in the
constant growth example. In addition to this previously noted effect, my
model illustrates the fact that growth option value is capitalized into
equity value, but not debt value, causing the leverage ratio to fall below
that predicted in MM (1963) and change with profitability.
The empirical literature largely focuses on cross-
sectional leverage determinants and simple tests aimed
at distinguishing the tradeoff theory from alternatives.
The findings I focus on are as follows. Titman and
Wessels (1988) and Rajan and Zingales (1995) show an
inverse relation between profitability and leverage.
Shyam-Sunder and Myers (1999) and Fama and French
(2002) show mean reversion in leverage ratios. Welch
(2004) shows the dependence of leverage ratios on past
stock returns.
The model is solved analytically for two cases:
investment irreversibility only, and irreversibility with
fixed costs. The solution builds on the real option
valuation approach of Merton (1973) and uses the
irreversible investment model similar to the one in
Morellec (2001). In the zero fixed costs case, firms invest
continuously along a boundary and have long periods of
inactivity away from the boundary. The empirical section
shows that irreversibility alone (without fixed costs) is
sufficient to replicate most empirical results, except for
lumpy adjustment. I also derive a solution for the model
with fixed costs using a scaling property.3 Investment in
the presence of fixed costs is lumpy and infrequent. This
leads to lumpy adjustment in the firm’s leverage ratio.
Following Strebulaev (2007), I use the calibrated model
to generate data. Each simulation results in an artificial
panel of data that is used to perform cross-sectional tests.
The simulations are repeated multiple times to achieve a
high degree of consistency; results are averaged across
simulations. The regression coefficients and the corre-
sponding t-statistics are compared to the results com-
monly found in the empirical capital structure literature.
I find that the results are generally consistent with
empirical evidence.
The rest of this paper is organized as follows. Section 2
states the assumptions and works out a single option
example. Extending the analysis to multiple options,
Sections 3 and 4 present the model with irreversible
investment, without fixed costs and with fixed costs,
respectively. Section 5 describes the simulation procedure
and the empirical tests on the simulated data. The final
section offers concluding remarks.
2. Simple setting with one growth option
To highlight the basic framework, I first consider a
simple setting in which the firm holds a single growth
option. My approach here is similar to that of Sundaresan
and Wang (2006) who work with a finite collection of
growth options. Although the single growth option model
is rather simple, it still generates the main results that
I derive below for the more general model with an infinite
number of growth options. For example, in the simple
model, the market leverage ratio is declining in profit-
ability and is mean reverting; adjustments in capital
Goldstein, Ju, and Leland (2001), Strebulaev (2007), and Kurshev
and Strebulaev (2006) use a scaling approach to describe capital
structure adjustments while keeping investment fixed. Hennessy and
Tserlukevich (2006) use scaling to solve a convertible/callable bond
model allowing for upward and downward debt adjustment.
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252
structure are lumpy whenever there are fixed costs of
investment.
As in the remainder of the paper, I consider two real
frictions: irreversibility and fixed costs of investment.
Irreversibility refers to the existence of a wedge between
the price at which capital can be purchased and the price
at which it can be sold. For example, physical capital, once
installed, can become firm-specific and hence has little or
no resale value. Fixed costs of investment refer to costs
that are a function of the size of the existing capital stock
rather than the size of the new investment. For example, if
a new investment project disrupts current business
operations, fixed costs are incurred.
2.1. Optimal financing policy and leverage
I now state the assumptions used in the framework.
Assets in place ðKÞ costlessly produce one unit of a
nonstorable good at each instant. The price p of the
output satisfies an inverse demand function with constant
elasticity.4 Demand is D ¼ ðp=X t Þ1=a1 with a 2 ½0; 1Þ. The
firm is a monopolist, implying p ¼ X t K a1 . Revenue is
equal to output price times output: pK ¼ X t K a . The
demand shock X t follows a geometric Brownian motion
(GBM)
dX t
¼ m dt þ bi sm dM t þ si dBt . (1)
Xt
Here sm dM t is a common random component (market
influence) and si dBt is an idiosyncratic shock. The
common component is designed to capture in a simple
form the changes in macroeconomic conditions. The
variables M t and Bt denote uncorrelated Brownian
motions. The total variance of the shock is
s2  ðb2i s2m þ s2i Þ.
Firms can adjust leverage costlessly. There is no agency
conflict between debt and equity, and the firm imple-
ments the first-best capital structure. Costless debt
adjustment is possible, for example, when debt takes the
form of private bank loans or is closely held. As stated in
the introduction, this assumption is adopted for the sake
of logical clarity and analytical tractability. The sections
that follow discuss the implications of relaxing this
assumption.
I assume a simple tax structure that creates a tax
advantage to debt as long as revenue is larger than
interest payments. The corporate tax rate tþ c is levied on
positive taxable income, and t c is levied on negative
taxable income. I assume that t c otc to approximate the
þ
effect of loss limitations. Individuals pay tax on interest
income at the rate ti 4t c . This assumption ensures that
there is a tax advantage to debt if and only if corporate
taxable income is positive. There is no tax deduction for
asset depreciation, although I discuss the effect of
depreciation separately in later sections. Dividend and
capital gain taxes are zero.
4
Input prices are assumed to be fixed, although it is possible to
present the same argument with the firm being a price taker with
stochastic input costs.
235
The firm has an option to increase its capital stock K to
the new optimal value by paying fixed and proportional
costs of investment.5 The investment cost structure
resembles that used by Abel and Eberly (1994). The cost
of changing the capital stock from K 0 to K 1 is
COSTðK 1 ; K 0 Þ
¼ P maxðK 1  K 0 ; 0Þ  P maxðK 0  K 1 ; 0Þ þ FPK 0 . (2)
The first term in this expression is the cost of buying
capital. The second term represents the amount that can
be recovered when assets are sold. Irreversibility entails
P  oP. For simplicity, I assume P  ¼ 0, meaning that
investment is perfectly irreversible. This is in contrast to a
common assumption that buy and sell prices are the same
(e.g., Brennan and Schwartz, 1984). Finally, the last term
(which is assumed to be equal zero if there is no
investment) is the fixed cost of investment, i.e., a cost
that depends on the initial capital stock, not on the size of
the investment per se.
The following lemma highlights that, when rebalan-
cing is costless, the optimal financing policy entails
setting the debt coupon equal to revenue (XK a ), shielding
all corporate income from taxation.6 The casual intuition
might suggest that the equity value is then equal to zero
and the leverage ratio is 100%, but as I later show, this
does not have to be the case.
Lemma 1. Under the optimal financing policy, instanta-
neous interest expense is equal to X t K a :
Proof. Consider a firm with revenue XK a that optimizes
its debt service strategy by choosing its interest payment i.
If XK a 4i, then the flow of tax savings is iðtþ c  ti Þ40. If
XK a oi, then the flow of tax savings is iðtc  ti Þo0. &
It is worth noting that in the model there are no
bankruptcy or agency costs of debt. This includes asset
substitution (Jensen and Meckling, 1976), free cash flow
problems (Jensen, 1986), and underinvestment problems
(Myers, 1977). For example, Barclay, Morellec, and Smith
(2006) present a capital structure model with debt
balancing under- and overinvestment problems. They find
that growth options have negative debt capacity; that is,
firms anticipating investment decrease their book lever-
age. The causation in their model differs from that
presented here in that the firm in their model takes on
less debt to mitigate the underinvestment problem. Such
effects are necessarily absent from my model since the
firm implements the first-best financing policy and the
manager works in the interests of shareholders.
Note that in the setting considered, it is optimal to
distribute cash. Auerbach (2001) and Graham (2000)
demonstrate the tax disadvantage to corporate savings.
Leland (1994) shows that accumulating cash is equivalent
to reducing debt for tax purposes. Since there are no
financing frictions in my model, there are no precau-
tionary motives to offset this tax disadvantage. Mauer and
5
It is straightforward to extend this model to allow for convex
instead of proportional costs.
6
Brennan (1986) describes debt policy in the case of free adjust-
ment.
 ARTICLE IN PRESS
236 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252

Triantis (1994) argue that holding cash increases financial 2.2. Valuation of the investment option
flexibility when external financing is costly.
Consider first a firm with capital K 0 that does not have Consider now a firm that holds a single option to
any growth options. Define VðX t ; K 0 Þ as the total (after-tax) increase its capital from K 0 to K 1 by paying a proportional
value of the firm. It is equal to the present value of after- and fixed cost PðK 1  K 0 Þ þ PK 0 IðK 1 4K 0 Þ.7 Shareholders
tax revenues ð1  ti ÞX t K a0 that grow at the rate m and are maximize over the time of exercise and the amount of
discounted at the tax-adjusted risk-free rate rð1  ti Þ: new capital K 1 . Since the option maturity is assumed to be
infinite, the problem is time independent. Therefore,
VðX t ; K 0 Þ
Z  investment is triggered when the demand shock reaches
1
X t K a0 ð1  ti Þ some critical value X  ; the corresponding stopping time is
¼ Et erð1ti Þs ð1  ti ÞX s K a0 ds ¼ . (3)
t rð1  ti Þ  m defined as T I  minðT; X T XX  Þ. Write the shareholders’
According to Lemma 1, the firm optimally sets an equity value as a sum of the value of assets in place (net of
instantaneous interest payment equal to revenue X t K a0 . debt) and the value of the option:
The owner of each unit of debt is entitled by the contract Z T I 
KaXt
EI ðX t ; K 0 Þ ¼ max ðð1  ti ÞEX t eð1ti Þrs X s K a0 ds  0
to receive a fixed debt coupon payment. But the firm can TI 0 r
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}
adjust the total interest payment in response to a change value of assets-in-place net of debt
Z 1 
in revenue by issuing (or repurchasing) additional debt. þ max ð1  ti ÞEX t eð1ti Þrs X s K a1 ds  EX t ½eð1ti ÞrT I PK 1 Þ ,
The debtholders who purchase corporate debt when the K1 TI
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}
shock is X t will be receiving a (fixed) after-tax interest present value of the growth option

payment ð1  ti ÞX t K a0 . The value of debt D is equal to the (7)

perpetuity of expected interest payments:
where EX t denotes the expectation operator at time t. First,
DðX t ; K 0 Þ consider the maximization problem with respect to the
Z  investment amount K 1 at the time T I . Using (3), we can
1
X t K a0
¼ Et erð1ti Þs ð1  ti ÞX t K a0 ds ¼ . (4) write the first-order condition of (7) with respect to K 1 :
t r
 1=ð1aÞ
The value of the residual equity claim is the difference ð1  ti ÞaX 
K 1 ðX  Þ ¼ . (8)
between the value of the assets and the value of debt: Pðrð1  ti Þ  mÞ

mX t K a0 Next, after substituting capital (8) into (7), the equity

EðX t ; K 0 Þ ¼ VðX t ; K 0 Þ  DðX t ; K 0 Þ ¼ . (5) value can be maximized with respect to the investment
r½rð1  ti Þ  m
threshold, X  .
When there is a positive demand shock, the firm issues
new debt and distributes the proceeds to shareholders. Proposition 1. Denote constant
Negative shocks lead to retirement of debt. I assume that sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 
shareholders can finance the retirement by selling more 1 m 1 m 2 2rð1  ti Þ
bðs; m; rÞ   2 þ  2 þ . (9)
equity or issuing rights. Note that if m ¼ 0, debt value is 2 s 2 s s2
equal to the value of assets in place, and the equity value The option is exercised at the first passage of the demand
(5) is zero. This is intuitive because the expected proceeds shock to the threshold value X  , defined by
from selling new debt (if a shock is positive) are equal to
 
the expected costs of retiring debt (if a shock is negative). Pðrð1  ti Þ  mÞ 1a ab ða1Þ=a
X ¼ K0 1 , (10)
The leverage ratio is equal to debt (4) divided by the ð1  ti Þa b1
total value of the assets (3):
and the value of this option at X t is
DðX t ; K 0 Þ rð1  ti Þ  m
LRt ¼ ¼ . (6) GOðX t ; K 0 Þ
VðX t ; K 0 Þ rð1  ti Þ
ð1  ti ÞaK a0
Evidently, the leverage ratio of the firm without growth ¼ X 1b X bt . (11)
rð1  ti Þ  m ððb  1Þ  abÞ 
options is constant, independent of the revenue. This is
consistent, for example, with Strebulaev (2007), who finds Proof. See the Appendix.
that the leverage is the same at each refinancing point.
The total equity value is equal to the value without
Further, observe that the leverage ratio in (6) is below
options (5) plus the value of the growth option (11). That
one if m40. This might at first seem surprising given that
is, for X t oX  where the option is ‘‘alive’’,
the firm issues debt to shield all revenues from tax. The
reason is that the value of debt is proportional to the mX t K a0
current revenues from assets in place, while equity value EðX t ; K 0 Þ ¼
rðrð1  ti Þ  mÞ
incorporates expectations regarding growth in revenues  b
ð1  ti ÞaK a0 X  Xt
from assets in place. This effect has been noted by Berens þ . (12)
rð1  ti Þ  m ððb  1Þ  abÞ X
and Cuny (1995) and highlighted in Ross, Westerfield, and
Jaffe (2002). They show that the leverage ratio falls below
the 100% figure predicted by Modigliani and Miller (1963). 7
Here, I set F ¼ 1 in the cost function for simplicity; the exact form
Berens and Cuny derive the optimal constant leverage and of the fixed cost is not important in the case of the single growth option
do not endogenize the firm’s growth. since the solution is already constrained.
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 237

leverage ratio
0.85

0.8

Leverage ratio 0.75

0.7

0.65

0.6

0.55

0.5
0 5 10 15 20 25 30 35 40
Demand shock
Market leverage ratio of the firm with a single growth
option as a function of demand shock.
Debt value
1400

1200

1000
Debt value

800

600

400

200

0
0 5 10 15 20 25 30 35 40
Demand shock
Debt value of the firm with a single growth option as a
function of demand shock.

Fig. 1. Firm with single irreversible investment option. All graphs are plotted against the value of demand shock. The critical value of the shock X  that
triggers investment corresponds, approximately, to the middle of the horizontal scale. The example assumes fixed investment costs ðF ¼ 1Þ and also
adopts a requirement that a firm has a single growth option. Parameters used in this example are s ¼ 0:2, I ¼ 10, a ¼ 0:2, and K ¼ 1. Panel A plots market
leverage ratio; Panel B plots the value of debt.

One can immediately see that the growth option value is
positive and is homogeneous of degree b41 in X t .
That is, the growth option value grows faster than the
value of assets in place and debt. Since debt value
increases more slowly than firm value, the leverage ratio
declines with positive shocks until the growth option is
exercised.
Turning to Fig. 1, I briefly discuss the implication of
financing policy for the firm with an investment option.
The figure plots the leverage ratio and debt against the
 ARTICLE IN PRESS
238 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252
demand shock.8 In other words, this is what one would
see if demand grew predictably and constantly over time.
The critical value of the shock X  approximately corre-
sponds to the middle of the horizontal scale. The market
leverage ratio (Panel A of Fig. 1) falls in profitability on the
left side of the graph, i.e., as long as the growth option is
not exercised. However, at X  the firm exploits its growth
option and issues debt. As a result of this debt issuance,
the leverage ratio spikes upwards (right side of the graph).
Next, as Panel B shows, the firm issues debt at the
investment to shield the higher revenue from tax. In my
model, the proceeds from selling debt are significant, and
often larger than the investment cost. This happens
because the irreversible investment is optimally delayed
until the value of the expected incremental cash flows
from the new investment becomes much larger than the
cost of the investment.9
Note that depreciation decreases the tax benefit of
debt and reduces the propensity to issue debt after
investment. However, since depreciation is based on the
cost of the installed capital (as opposed to value) and
does not increase with time, it can only marginally reduce
the amount of issued debt. In addition, I do not allow for
the ‘‘time to build’’ when formulating the simple invest-
ment strategies. Since new capital is installed instanta-
neously and immediately produces cash flows, the firm
sells a significant quantity of debt. Tsyplakov (2008)
discusses time-to-build and its effect on financing with
debt.
For the empiricist who investigates the data properties,
the behavior of the leverage ratio seems to be consistent
with the presence of refinancing costs. In my model, the
leverage ratio changes because of the change in the
growth option value. The jumps in the leverage ratio
exhibited by my model are commonly attributed to fixed
financing costs. I explain it within the model by the fixed
costs of investment. That is, the explanation relies on real
costs as opposed to financing frictions.
2.3. Adjustment costs
The analysis of the real options effect on financing
behavior in this paper has so far relied on the assumption
of frictionless rebalancing. While this restricted approach
is helpful in understanding a number of phenomena, it
has important limitations. With regard to the question
posed in the title of this paper—‘‘Can real options explain
financing behavior?’’—the real options model stripped of
adjustment costs can explain surprisingly many docu-
mented regularities, but certainly not all of them. For
example, in the model with free leverage adjustment, debt
is risk-free and is rebalanced continuously. The mean
leverage is high relative to empirical estimates because of
the zero bankruptcy costs assumption. In addition, the
model predicts too little variation in leverage for firms
without significant growth options.
8
The example assumes the following parameters: m ¼ 1%, r ¼ 5%,
s ¼ 20%, X 0 ¼ 10, P ¼ 10, a ¼ 0:2, ti ¼ 10%, and K 0 ¼ 1.
9
Chen and Zhao (2006) investigate the active issuance decisions and
find that firms primarily issue debt before the investment.
In attempting to produce even the basic model of
investment and financing under two types of frictions, one
can quickly become inundated with mathematical com-
plexity. However, using relatively simple examples, it is
easy to answer the most important question: do adjust-
ment costs and real frictions complement each other in
explaining the capital structure evidence? This question
speaks directly to the puzzles that we attempt to resolve
since both types of frictions have been independently
shown to contribute to the explanation.
To highlight the role of adjustment costs and their
interaction with real frictions, I construct a set of
examples in Fig. 2. The solid line in the graphs gives the
leverage ratio under frictionless rebalancing. The dashed
line is the actual leverage ratio. The first example (Panel A)
simply replicates existing studies and computes the
leverage ratio for the firm (without growth options) that
is restricted to adjust its debt infrequently. For simplicity
I assume that the firm can adjust debt only once. The
leverage ratio variation in this case closely resembles that
with growth options and no adjustment costs (compare,
e.g., to Fig. 1). Two frictions produce similar effects on the
leverage ratio; however, I show below that the mechan-
isms of these effects are different.
In the second example (Panel B), the firm holds a single
growth option. I assume that the threshold for exercising
the option is fixed and that rebalancing coincides with
investment. As the graph demonstrates, the combined
effect of real and financing frictions is larger than the
individual effects. When profitability increases, the
growth option increases the denominator of the leverage
ratio. At the same time, adjustment costs restrict increas-
ing debt in the numerator. Consequently, the leverage
ratio declines with profitability. We can think of the first
effect as a change in the target leverage and of the second
effect as a deviation from this target. The two effects are
positively correlated and produce a larger variation in
leverage than under financing costs alone (compare Panel
A to Panel B).
Next, I introduce bankruptcy costs and investigate their
effect on leverage dynamics (Panels C and D). I model
bankruptcy in the following way: the bankruptcy is
triggered when cash flows fall below interest payments
and the firm defaults. After default, a portion of the firm
value (assumed to be 50% in this example) is lost due to
reorganization, and the remaining portion is assumed by
debtholders.
Introduction of bankruptcy costs decreases the initial
optimal leverage and increases the profitability-leverage
sensitivity. First, observe that in Panels C and D the initial
optimal leverage ratio and the post-adjustment leverage
are significantly lower when there are bankruptcy costs
(e.g., compare Panels C and A). Second, leverage of the
risky firm exhibits a larger increase at low profits and a
larger decline at high profits (compare Panels C and D).
When profits are low, bankruptcy threatens to eliminate
the growth options in addition to imposing liquidation
costs on assets in place. When profits are high, the assets
in place become safer and the value of the growth option
increases. In addition, note that because of the positive
bankruptcy costs assumption, the corporate bond yield is
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 239

1 1

0.9 0.9

0.8 0.8
Leverage ratio

Leverage ratio
0.7 0.7

0.6 0.6

0.5 0.5

0.4 0.4

0.3 0.3

0.2 0.2
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Demand shock Demand shock
Leverage ratio can be adjusted once. No growth options. Leverage ratio when debt can be adjusted once. The firm
holds a single growth option.

0.9 0.9

0.8 0.8

0.7 0.7
Leverage ratio

Leverage ratio

0.6 0.6

0.5 0.5

0.4 0.4

0.3 0.3

0.2 0.2

0.1 0.1
5 10 15 20 25 30 35 40 5 10 15 20 25 30 35 40
Demand shock Demand shock
Leverage ratio when debt can be adjusted once. No Leverage ratio when debt can be adjusted once. The firm
growth options. Bankruptcy costs are 50%. holds a single growth option. Bankruptcy costs are 50%.

Fig. 2. Interaction of real and financing frictions. All graphs are plotted against the value of the demand shock under base parameters. The critical value of
the demand shock X  that triggers investment corresponds, approximately, to the middle of the horizontal scale. The solid line is the leverage ratio for the
firm without financing frictions. The dashed line is leverage with financing frictions. The firm can adjust only once at the time of the investment; it is also
assumed that the option exercise threshold is fixed for all graphs. Panels A and C are for the firm without growth options; Panels B and D are for the firm
with a single growth option. Exhibits C and D assume that bankruptcy is triggered when cash flows are equal to the interest payment and bankruptcy
costs are 50%.

also positive. This can be contrasted with the frictionless
case where debt is riskless and therefore can be issued at
the risk-free rate.
The section that follows develops a multiple invest-
ment options model capable of generating a uniform
panel of data. Although single-option examples offer
many insights, they are not suitable for generating
panel data and running cross-sectional regressions. Since
firms gradually exercise their options, the cross section of
the data in the early years looks very different from that in
the later years. To ensure continuity, we must assume that
the number of growth options that firms hold is not
bounded.
3. Irreversible incremental investment
This section treats the case of a firm with an infinite
basket of growth options. I first assume that there are no
fixed costs of investment. The section that follows
considers the optimal investment and financing program
for a firm facing irreversibility and fixed costs. The
independent analyses are interesting in that they illus-
trate the powerful effect that alternative real cost
assumptions have on financial policies.
The model presented below incorporates debt optimi-
zation and is similar to Morellec (2001). Morellec models
irreversible sales of capital and the optimal asset

240
abandonment strategy that maximizes the value of the
levered (risky) firm by increasing liquidity. In contrast, the
firms in my model do not need to downsize when they
face negative news because I assume that financial
leverage can be adjusted costlessly and that there are no
costs associated with carrying excess capital.
Assume that shareholders maximize the firm value
net of investment costs, with respect to the investment
policy KðXÞ:
Z 1
EðX t ; KÞ ¼ max EX t ðerð1ti Þs ð1  ti ÞX s K a ðX s Þ  K a0 X t Þ ds
KðXÞ t threshold xðKÞ:
Z 1
 PEX t erð1ti Þs maxð0; dKðX s ÞÞ.
t xðKÞ ¼
The first term in (13) is the present value of revenues net
of debt payments, and the second term is the present
value of investment costs. To facilitate the solution to this
problem, consider the change in equity value EðK; X t Þ
between t and t þ dt. The value of equity at time t is equal
to the value of dividends paid between t and t þ dt plus
the expected equity value at t þ dt net of investment costs
(Bellman equation):
mK a X t
EðK; X t Þ ¼ max½ dt þerð1ti Þ dt
0
K r
|fflfflfflfflfflffl{zfflfflfflfflfflffl}
Dividend
ðEðK 0 ; X t þ dX t Þ  PðK 0  KÞÞ ,
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}
Expected equity value net of costs
where K ¼ KðX t Þ and K 0 ¼ KðX tþdt Þ. The first derivative of
(14) with respect to K 0 produces the condition for optimal
investment—the marginal value is equal to the marginal
cost,
EK ðX t ; KÞ ¼ P s.t. K 0 XK.
Note that due to the irreversibility assumption, changes in
capital must be nonnegative. The existence of the solution
is guaranteed by concavity of the function in the second
argument (see, e.g., Dixit and Pindyk, 1994). Note that the
problem is time independent because the maturity of the
options is infinite.
It is intuitive that the firm will invest irreversibly if the
demand shock X t is high and that it will be passive if the
shock is low. Denote the threshold for investment xðKÞ.
The region in ðX t ; KÞ space where X t oxðKÞ is termed an
‘‘inaction region’’ since no new investment is made there.
In this region, K 0 ¼ K, and the value of equity satisfies the
following differential equation:
mK a X t
 rð1  ti ÞEðX t ; KÞ þ mX t E0 ðX t ; KÞ
r
1 2 2 00
þ s X t E ðX t ; KÞ ¼ 0,
2
subject to the boundary conditions at the investment
threshold xðKÞ,
EK ðxðKÞ; KÞ ¼ P,
EKX ðxðKÞ; KÞ ¼ 0.
The first of these conditions, which follows from (15), is
equivalent to the value-matching condition at the bound-
ary between the ‘‘inaction’’ and ‘‘investment’’ regions. The
ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252
second (18) requires continuity of the first derivative of
(15) at the boundary.10 In addition, the standard require-
ment is that the solution of (16) must be finite for small
values of X t :
EðX t ; KÞo1 for X t ! 0. (19)
I provide the solution to Eq. (16) subject to conditions
(17)–(19) in the following proposition.
Proposition 2. The optimal policy under linear costs of
investing entails increasing capital whenever X t reaches the
 
(13) b ðrð1  ti Þ  mÞP
. (20)
b  1 ð1  ti ÞaK a1
Equity value under this policy is given by
mK a X t
EðK; X t Þ ¼ þ GOðK; X t Þ, (21)
ðrð1  ti Þ  mÞr
and the growth options value is
 b1  b
b1 að1  ti Þ
GOðK; X t Þ ¼
P bðrð1  ti Þ  mÞ
K ða1Þbþ1
 Xb. (22)
ð1  aÞb  1 t
Proof. See the Appendix.
(14)
The proposition shows that when cost of capital
accumulation is proportional to the change in capital
P DK, the solution is given by a ‘‘barrier policy.’’ The barrier
xðKÞ is the critical value of the shock that justifies
installation of an additional unit of the capital. However,
the firm never crosses the barrier: when X t reaches xðKÞ;
(15) new investment keeps the firm from crossing it.
Fig. 3 provides an illustration of the investment and
financing policy in this case. The graphs in Fig. 3 are based
on a single simulation and one randomly selected firm. For
better illustration, I choose to keep the full (without trun-
cation) time series of the data observed over 400 quarters.
Panel A presents a sample random path of X t . For this
particular path, I plot the dynamic changes in optimal
capital and leverage. Panel B shows that the amount of
installed capital is non-decreasing in the demand shock.
The firm increases its capital incrementally when shock X t
reaches its new historical high. Panel C displays the
market leverage ratio corresponding to the path X t .
Interestingly, for this particular path, the increments
are, on average, positive in the beginning. Therefore, the
leverage ratio is initially low due to the valuable growth
options. Later on, the shock increments reverse and X t
declines. Consequently, the leverage ratio sharply in-
(16) creases. As explained in the introduction, the market
leverage ratio is expected to depend on the path of past
stock returns. It is easy to see from the example that a firm
that experiences a run-up in stock price followed by a
(17) decline has a high leverage ratio. This is because the firm
operates with an excess capacity that cannot be shed.
(18) Debt value is high because taxable revenues are high. At
10
See Dumas (1991), Dixit (1993), and Morellec (2001) for
discussion and applications of the ‘‘super-contact condition.’’
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 241

path capital
40 12

35 11
10
30
9
Demand shock

25

Capital stock
8
20 7

15 6
5
10
4
5
3
0 2
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400
Time Time
Random path of the demand shock Actual amount of capital stock
leverage
0.6
0.55
0.5
0.45
Leverage ratio

0.4
0.35
0.3
0.25
0.2
0.15
0.1
0 50 100 150 200 250 300 350 400
Time
Market leverage ratio

Fig. 3. Incremental investment without fixed costs. All graphs are plotted against time and based on one randomly selected economy simulation for a
randomly selected firm. This case is for zero fixed costs ðF ¼ 0Þ. Figures generated for a sample path of the demand shock are displayed in Panel A. Panel B
shows the optimal (non-decreasing) amount of capital stock. Panel C is the market leverage ratio corresponding to this path.

the same time, the value of growth options is low since ratio, would pick up these effects in the regressions.
the firm is far away from the investment threshold. The But I show that typically this is not the case. The reason is
result is that firms in sectors where the state variable that the book-to-market ratio that measures the departure
(demand) has declined significantly relative to historic of the market price from the book value is different from
highs are predicted to have high leverage ratios. the ratio of the growth options value to the market value
A similar argument can explain why, keeping profit- from assets in place that determines the leverage ratio in
ability fixed, size is positively related to leverage in the the model. For example, for a firm that has no growth
simulations. All else equal, larger size means that the firm options, the firm’s market value increases and the book-
has exercised more growth options. The installed capacity to-market ratio decreases with profitability. However, the
erodes the value of subsequent growth options and leverage ratio remains constant since debt increases
increases the leverage ratio. Therefore, my model can proportionally.
offer an alternative explanation to the size-leverage
puzzle on the basis of real options. Kurshev and Strebulaev
(2006) obtain a positive cross-sectional relation by 4. Irreversible investment with fixed costs
introducing fixed costs of adjusting debt.
It might appear that including some common proxies Consider a firm facing two ‘‘real frictions’’: irreversi-
for growth options, such as the book-to-market value bility and fixed costs of investment. In the presence of

242 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252
fixed costs, continuous investment is infinitely expensive.
Consequently, the firm invests in lumps, with bursts of
investment spaced in time. This complements the main
model that replicates ‘‘smooth’’ investment only.11
At date t, the manager maximizes equity value by
choosing the investment stopping times and the size of
the capital adjustments:
1 Z
X T Nþ1
EðK 0 ; X t Þ ¼ EX t erð1ti Þs ð1  ti ÞX s K aN ds
N¼0 TN
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}
present value of cash flows
X
1
X t K a0
EX t erð1ti ÞT N ðPK N Þ 
r
|ffl{zffl}
N¼1
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} Debt
present value of investment costs
In (23), the summation is over the number of unex-
ercised options; I use notation T 0  t for current time and
K 0 for current capital. Discrete stopping times fT 1 ; T 2 ; . . .g
are contingent on future realizations of the demand shock
X t . In particular, investment is triggered when X t reaches
one of the thresholds fX 1 , X 2 ; . . .g, that satisfy
T N ¼ minðt; X t XX N Þ. Note that since the options have
infinite maturity, the investment thresholds fX 1 , X 2 ; . . .g
are independent of time.
As I show below, the homogeneity of the maximization
function reduces the problem to essentially a static
optimization. The firm simply optimizes over a single
‘‘scaling’’ parameter g ¼ X Nþ1 =X N that fully characterizes
the optimal investment thresholds. This can be contrasted
with a non-homogeneous setting in which the firm must
optimize over an infinite sequence fgt gtX1 .
According to Proposition 3, this strategy is ‘‘regret-
free’’; in that the firm that has assumed a constant g in
perpetuity when formulating its initial investment strat-
egy will indeed find the same g optimal in each
investment round.
Proposition 3. Let K 0 ðX t Þ denote the initial choice of capital.
The optimal investment strategy entails increasing capital to
K n ¼ gn=ð1aÞ K 0 upon first passage of X t to X n ¼ gn X 0 ;
n ¼ 1 . . . 1. The scaling parameter g41 maximizes12
ð1  g1b Þa=ð1aÞ
ðm þ ðr  mÞg1=ð1aÞb
1  g1=ð1aÞb
þ r g1b  ð1  g1b Þar g1=ð1aÞb Þ.
11
Frictions such as fixed costs are not the only way to generate
investment lumpiness. For example, Guo, Miao, and Morellec (2005)
show that if underlying processes exogenously shift between different
states, investment is intermittent but can exhibit spurts of growth.
12
For the solution to converge, it must be that
1=ð1aÞb 1
ð1  g Þ40 ) b4 .
1a
Here bðr; m; s2 Þ is increasing in r and decreasing in m and s2 . The
condition above ensures that the value of the future growth options is
finite. The direct analogy is a Gordon’s growth formula V ¼ X=ðr  mÞ that
requires mor.
ARTICLE IN PRESS
Optimal initial capital, K 0 ðX t Þ is
 1=ð1aÞ
ð1  ti ÞX t a
K 0 ðX t Þ ¼ ð1  g1b Þ . (25)
Pðrð1  ti Þ  mÞ
Proof. See the Appendix.
Much intuition for the proof of Proposition 3 can be
gained by considering the following argument. Starting at
X 0 , assume that the optimal capital stock is K 0 , and the
next threshold for investment is X 1 . Define the factor
g1 ¼ X 1 =X 0 . That is, g1 is a factor by which one has to
multiply the initial value of the shock to obtain the first
investment threshold. For example, if g1 ¼ 2, the firm
. (23)
invests when the shock value doubles.
With this definition in mind, consider the problem of
solving for the next threshold X 2 ¼ g2 X 1 , keeping other
thresholds fixed. The assumptions of the model guarantee
that the optimal capital, cost of investment, and revenue
at X 1 are scalar multiples of the original capital, cost, and
revenue at X 0 . In particular, the optimal capital increases
between X 0 and X 1 by a factor of g1=ð1aÞ . The cost of
investment, which is proportional to the capital stock, also
increases by a factor of g1=ð1aÞ . Revenue X t K a increases by
a factor ðg1 ga=ð1aÞ Þ ¼ g1=ð1aÞ. The remaining investment
options grow by the same factor. Therefore, the max-
imization problem for the new threshold X 2 is just a scalar
multiple of the original problem, hence g2 ¼ g1 .
The expression for capital (25) is similar to the one in
the single option (8), except for the term ð1  g1b Þ that
accounts for the option to increase capital in the future.
It also follows from Proposition 3 that g is independent
of the cost parameter P. Intuitively, proportional cost
P decreases the initial investment and all subsequent
investments, but does not change the ratio between them.
Fig. 4 illustrates the case of irreversible investment
with fixed costs. The graphs for Fig. 4 are plotted against
time, using a single realization of the stochastic demand
shock (Panel A). Panel B shows the amount of the capital
stock corresponding to this path. The investment is
triggered when the demand shock reaches the set of
critical levels defined by Proposition 2. For this particular
example, the investment is completed in quarters 91, 110,
113, and 137. It is visible on the graph as jumps in the
capital stock value. Panel C shows the plot of the debt
value corresponding to the path realization. Debt con-
tinuously increases in revenue. However, debt increases in
lumps when new debt is issued at the time of investment.
(24) Finally, the market leverage ratio that corresponds to this
path is plotted in Panel D. The market leverage ratio
decreases with profitability, and the relation reverses at
the exercise. The leverage ratio is higher on the right side
of the graph due to the lower growth options value.
Next, I use models with and without fixed costs to
generate the data and perform the empirical tests.
5. Data and empirical results
The nonlinear nature of the equations in the model
prevents me from making a direct estimation. Therefore,
I take a simulation approach used in previous studies. For
example, Hennessy and Whited (2005), Strebulaev (2007),
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 243

path capital
250 2.5

200 2
Demand shock

Capital stock
150 1.5

100 1

50 0.5

0 0
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400
Time Time
Random demand shock path Capital stock
debt leverage
6000 0.75

0.7
5000
0.65
4000
0.6
Leverage ratio
Debt value

3000 0.55

0.5
2000
0.45
1000
0.4

0 0.35
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400
Time Time
Debt value Market leverage ratio

Fig. 4. Irreversible investment with fixed costs. All graphs are plotted against time and based on one randomly selected economy simulation for a
randomly selected firm. The simulation assumes maximum fixed costs ðF ¼ 1Þ. Figures are generated for a sample path of the demand shock that is shown
in Panel A. The capital stock adjustments corresponding to this sample path are depicted in Panel B. The firm invests (in this particular simulation) at
quarters 91, 110, 113, and 137, visible as jumps in the amount of capital. Panel C is the market value of debt corresponding to this path. Panel D is the
market leverage ratio corresponding to this path.

and Leary and Roberts (2005) use simulations to study
capital structure. Berk, Naik, and Green (1999) employ
this method to explain cross-sectional returns. I most
closely follow Strebulaev (2007) in the simulation and
estimation method. First, I calibrate the technology
parameters and simulate random price paths. Then, I use
these paths to create artificial panels of data for the
economy of firms. Next, I perform a number of tests
commonly employed in the empirical capital structure
literature. The focus of the tests is on commonly discussed
properties of the leverage ratio, such as the correlation
between leverage and profitability, the mean reversion
and the dependence of leverage on past stock returns.
I show that my model produces results that are qualita-
tively, and in most cases quantitatively, consistent with
existing empirical findings.
5.1. Simulation procedure
This section briefly explains the data-generating
process and outlines the main assumptions and defini-
tions. Firms within the economy are affected by common
market conditions, but do not interact with each other
through the equilibrium price. Given that the focus of my
paper is on capital structure, I assume that the firms
produce highly specialized products, and that an increase
in one firm’s output has no influence on the price that
another firm receives. Kogan (2001) solves the equili-
brium model of investment.
Parameters used in the simulations are summarized in
Table 1. In calibrating the model, I first fix the set of
parameters that can either be normalized or adopted from
previous studies. The initial shock value X 0 , which has a
 ARTICLE IN PRESS
244 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252

Table 1 shock dynamics defined by Eq. (1):

Parameter values used in simulations
The table summarizes the assumptions and parameter values that are X tþdt ¼ X t expððm  s2 =2Þ dt
used in the simulations. Empirically defined parameters are obtained
using 1965–2006 CRSP monthly returns data. The distribution of the þ si dWðtÞ þ bi sm dMðtÞÞ. (26)
firms’ systematic risk (represented by bi ) is obtained by running OLS
one-factor regressions of monthly returns (including dividends) for all Here WðtÞ and MðtÞ are uncorrelated BM processes and the
firms with at least 36 months of available data on the value-weighted market ‘‘beta,’’ bi , is a measure of the systematic risk of
index as a proxy for market. The market equity return volatility is
the firm.
calculated as a standard deviation of the value-weighted equity return
index. The individual equity return volatilities are computed as standard
I calibrate the inputs for the random process (26) using
deviations of the monthly returns on the individual stocks. Volatilities of an empirical sample from CRSP and COMPUSTAT for
asset returns for the market index, sm , and for stocks, s, are constructed 1965–2006. The distribution of the firms’ systematic risk
using standard deviations of equity returns as s ¼ ð1  LÞsequity , where (represented by b) is obtained by running an ordinary
L is the leverage ratio, which averages 0.292 in the COMPUSTAT sample
least squares (OLS) market factor regression of monthly
for 1965–2006. The idiosyncratic volatility, si , is calculated from the
total volatility, s, and the market component using formula (27) in the returns (including dividends) for all firms with at least 36
main text. Normalized and adopted parameters are selected as explained months of available data on the value-weighted index as a
in the text. proxy for the market. The mean and the variance of b
obtained through this procedure are 0.952 and 0.358,
Parameter Notation Determination Mean (Std. dev.)
respectively. The market return volatility is calculated
Drift of the demand shock m Adopted 1% from the monthly value-weighted index returns and is
Initial value of the shock X0 Normalized 10 equal to 0.153.
Fixed cost of investment F 0 or 1 – The volatilities of the returns on assets are constructed
Proportional cost P U½10; 100 55.0 (26.04)
using standard deviations of equity returns. To ensure
Demand elasticity a U½0:1; 0:2 0.15 (0.029)
Risk-free rate r Adopted 5% consistency with the model, I adopt the assumption that
Individual income tax rate ti Normalized 1% the volatility of debt returns and the correlation between
Corporate tax rate tc Adopted 35% debt and equity returns are small compared to the
Volatility (idiosyncratic) si Empirical 0.239 (0.098) volatility of equity returns. Then the standard deviation
Volatility (market) sm Empirical 0.1086
Market beta bi Empirical 0.952 (0.358)
of the returns on assets is estimated as s ¼ ð1  LÞsequity ,
Volatility (total) s Empirical 0.263 (0.099) where L is a market leverage ratio (defined below), which
averages 0.292 in my sample. The ‘‘unlevering’’ procedure
produces a single estimate of the systematic component
of volatility sm ¼ 0:109 and a sample of the total volatility
parameters, s, with a mean 0.263 and a standard
trivial proportional effect on the valuation, is normalized deviation 0.099. Finally, the idiosyncratic volatility is cal-
to 10 for all firms. Following Hennessy and Tserlukevich culated by subtracting the market component from the
(2006), I assume that cash flows grow at the rate (net of total volatility using the following formula:
depreciation) m ¼ 1% and that the risk-free rate is equal to qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
r ¼ 5%. I require the tax rate on individual interest income si ¼ s2  b2i s2m . (27)
to be positive, a sufficient condition to avoid situations
where the optimal debt is not determined. However, The idiosyncratic volatility estimates have a mean 0.239
I select a very small value ti ¼ 1% for the simulations to be and a standard deviation 0.098. Since volatility para-
consistent with other studies that do not emphasize the meters directly affect the value of growth options, I verify
role of individual taxes. I check that my results are not the robustness of the main results to changes in volatility.
affected if the higher values of individual tax parameter Analysis in the next section demonstrates that the main
are adopted. I assume that the proportional investment results remain significant when volatility parameters are
cost parameter, P, and the elasticity of demand, a, are varied within a reasonable range.
drawn from a uniform distribution on the domains Simulations produce panel data for 1,000 economies.
½10; 100 and ½0:1; 0:2, respectively. I therefore randomly select 1,000 sets of parameters
The demand shock consists of two parts: the idiosyn- fbi ; sm ; si g for the procedure from the empirical sample.
cratic part and the economy-wide shock that leads to a For the benchmark model, I simulate 400 quarters of data
correlation between cash flows of different firms. Econo- for firms, removing the first 100 quarters to minimize the
my-wide (systematic) shocks have no pricing implications impact of the initial conditions on the results. Simulations
under a risk-adjusted measure. But the common compo- are repeated 1,000 times, producing a sampling distribu-
nent is a source of cross-sectional correlation in residuals. tion for the statistics of interest.
Note that Hackbarth, Miao, and Morellec (2006) empha- Table 2 presents the descriptive statistics for leverage
size the role of the aggregate (multiplicative) shock and investment in the simulated economies. The market
component in explaining the level of debt in their model. leverage ratio is defined as the ratio of the book value of
I model the aggregate shock as an additive component to debt to the sum of the book value of debt and the market
facilitate comparison with earlier dynamic capital struc- value of equity:
ture papers that use this assumption.
Ito’s Lemma applied to the logarithm of Brownian Dt
LRt ¼ . (28)
motion produces a discrete-time representation of the Dt þ St
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 245

Table 2 panel of firms and compare the model-generated mo-

Descriptive statistics for the generated samples ments and regression coefficients with those observed in
The statistics are calculated from 1,000 independent simulations. For
real-world data.
each simulation, the values are computed in cross section and averaged
over time. The leverage ratio data includes mean, standard deviation, In all regressions, I employ the Fama-MacBeth (1973)
and 1%, 25%, 50%, 75%, 99% percentiles for the average mean and method to calculate robust standard errors. Following
maximum leverage ratios in the cross section. Investment statistics their method, I compute average coefficients from year-
include the number of quarters with investment (Quarters) and average by-year cross-sectional regressions and use the time
investment (Investment), calculated as the total lifetime investment
divided by the number of quarters where investment took place. For the
series of standard errors to draw statistical inferences.
zero cost model all quarters with nonzero intermittent investment are The t-statistics are calculated as average slopes divided by
included. Panel A gives results for the case without fixed costs, and the standard error, computed as the time-series standard
Panel B offers corresponding results for the case with fixed costs. deviation divided by the square root of the number of
observations. I average the slope coefficients and
Percentiles
t-statistics obtained by this method over 1,000 simula-
Mean 1% 25% 50% 75% 99% tions and provide distribution statistics of this sample in
the tables.
Panel A—Zero fixed costs model The simple theory of capital structure predicts a
Average leverage ratio 0.453 0.242 0.382 0.451 0.524 0.676
Minimum leverage ratio 0.002 0 0.001 0.001 0.003 0.017
positive relation between earnings and leverage, contra-
Maximum leverage ratio 0.775 0.728 0.767 0.778 0.786 0.796 dictory to the empirical evidence (see, e.g., Rajan and
Zingales, 1995). Strebulaev (2007) and Leary and Roberts
Investment/quarter 0.703 0 0.054 0.144 0.421 9.435 (2005) find that a negative relation can result from
Quarters w. investment 24.28 0 6 19.5 39 81.5 infrequent leverage adjustment in the presence of finan-
cial transaction costs. I run the same regression for the
Panel B—Fixed costs model model where transaction costs are explicitly set to zero.
Average leverage ratio 0.730 0.673 0.716 0.734 0.748 0.754 Profitability pt in the regressions is defined as the sum of
Minimum leverage ratio 0.032 0.003 0.012 0.027 0.046 0.113
Maximum leverage ratio 0.777 0.776 0.777 0.777 0.777 0.777
earnings and the increase in book value of assets divided

Investment/quarter 0.584 0 0.091 0.258 0.606 4.927

Quarters w. investment 0.58 0 1 2 7 12
Table 3
Leverage cross-sectional regression
Profitability pFF is defined following, e.g., Fama and French (2002), as
The mean leverage in the simulated data is 45% in the case
cash flows adjusted by the book value of assets. Profitability pBW is
without fixed costs and 73% in the case with fixed costs. defined as EBITDA (earnings before income, taxes, depreciation and
These estimates are higher than the typical average U.S. amortization) adjusted by the book value of assets as in Baker and
leverage ratio of about 30%.13 However, it is not a Wurgler (2002). Profitability pRZ is defined, following Rajan and Zingales
(1995), as an average profitability over the last four periods; that is,
surprising result because my assumptions rule out
pRZ;t ¼ 14ðpt4 þ pt3 þ pt2 þ pt1 Þ. The leverage ratio, LRt , is defined as
distress costs. As an example, imagine that firms (e.g.,
the ratio of the book value of debt to the sum of the book value of debt
due to the possibility of bankruptcy) adopt a strategy of and the market value of equity. Additional independent variables in the
keeping interest payments capped at half of revenues. In regressions are the volatility of cash flows ðsÞ and the demand elasticity
this case, the model would produce leverage ratios that ðaÞ. The number reported in parentheses for the standard deviation
are about twice as small. Observe that mean leverage is column is the standard deviation of the mean t-statistics across
simulations.
larger in the case with fixed costs. This is also expected
because growth options are, on average, less valuable Base definition pFF Alternative p definitions
when investment frictions are larger.
In addition to the leverage ratio properties, Table 2 Mean coefficient Std. dev. pBW pRZ
provides statistics on the average investment. For each
Panel A—Zero fixed costs model
firm, the average investment is calculated as total Constant 0.691 0.166 0.78 0.510
investment divided by the number of quarters with (140) (66.7) (101) (90.8)
nonzero investment. The average investment figures for Profitability p 0:591 0.256 7:550 1:376
ð8:70Þ (2.79) ð78:6Þ ð32:2Þ
the cases of zero and non-zero fixed costs are 0.703 and
Volatility s 0.601 0.324 0:163 0.358
0.454, respectively. Fixed costs permit larger, infrequent (48.9) (27.9) ð19:9Þ (36.3)
bursts of investment while reducing the total amount Elasticity a 2:342 0.277 1:434 1:503
invested in each period. ð228Þ (107) ð127Þ ð95:6Þ

5.2. Cross-sectional regressions Panel B—Fixed costs model

Constant 0.977 0.023 1.080 0.978
In this section, I investigate the cross-sectional proper- (357) (72.1) (149) (161)
Profitability p 0:127 0.033 2:761 0:504
ties of the model. I use the model to generate an artificial ð13:3Þ (3.0) (-78.0) ð59:5Þ
Volatility s -0.565 0.060 0:802 0:624
13
ð59:3Þ (11.0) ð65:3Þ ð47:1Þ
The leverage ratios reported by different studies vary due to the Elasticity a 0:747 0.146 0:715 0:705
difference in definitions and the sample selection. Most common ð99:0Þ (48.1) ð68:9Þ ð66:4Þ
estimates lie between 29% and 35%.
 ARTICLE IN PRESS
246 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252

by the book value of assets: four periods. That is,

Earningst þ dBt pRZ 1

t ¼ 4ðpt4 þ pt3 þ pt2 þ pt1 Þ. (30)
pt ¼ , (29)
Bt1
I run the following cross-sectional regression of market
where the term dBt in the numerator accounts for the leverage on profitability and two control variables,
difference between accounting earnings and free cash volatility si and the elasticity parameter ai :
flow. This definition is used, for example, by Fama and
LRti ¼ b0 þ b1 Pti þ b2 si þ b3 ai þ e, (31)
French (2002) and Strebulaev (2007). To investigate the
sensitivity of the regression results to this definition, I also where Pti
stands for profitability under the base and
employ two alternative definitions that are used in alternative definitions, P ¼ fpt ; pBW ; pRZ g. Results are
the literature. Following Baker and Wurgler (2002), summarized in Table 3. The first column gives the
I define profitability pBW as the ratio of EBITDA (earnings coefficients and t-statistics calculated with the Fama-
before income, taxes, depreciation and amortization) to MacBeth method and averaged using 1,000 simulations.
the book value of assets. This definition ignores the The last two columns present the results for the
correction between accounting earnings and free cash alternative definitions of profitability. The coefficients on
flow. Profitability pRZ is defined, following Rajan and profitability for the base and alternative profitability
Zingales (1995), as the average profitability over the last definitions are negative and significant. The average

Investment with zero fixed costs Investment with fixed costs

300 250

250
200
Values in the bin
Values in the bin

200
150
150
100
100

50
50

0 0
-2 -1.5 -1 -0.5 0 -0.3 -0.25 -0.2 -0.15 -0.1 -0.05
Coefficient value Coefficient value
Profitability coefficient Profitability coefficient
350 300

300 250

250
Values in the bin

Values in the bin

200
200
150
150
100
100

50 50

0 0
- 0.21 - 0.2 - 0.19 - 0.18 - 0.17 - 0.16 - 0.15 - 0.14 - 0.13 - 0.24 - 0.22 - 0.2 - 0.18 - 0.16 - 0.14 - 0.12
Coefficient value Coefficient value
Mean reversion coefficient Mean reversion coefficient

Fig. 5. Frequency distribution histograms of the coefficients for profitability and mean reversion regressions. The coefficients are obtained from 1,000
independent observations by running cross-sectional regressions and averaging the result over time. Panel A (left side of the exhibit) is for zero fixed costs
ðF ¼ 0Þ; Panel B (right side) is for the fixed costs case ðF ¼ 1Þ. The upper graphs give the distribution of the profitability coefficient b1 over the simulations.
The lower graphs give the distribution of the mean reversion coefficients.
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 247

estimated coefficient on the profitability variable (base
definition) is 0:59, with an average t-statistic of 8:7 for
the case with no fixed costs. I find an average coefficient of
0:13 and the average t-statistic of 13:3 in the case with
fixed costs.
These results are broadly consistent with existing
empirical evidence. For example, Fama and French
(2002) report coefficients of around 0:6. Fig. 5, Panel A,
displays a histogram with the distribution of coefficients
in the simulation sample. It is easy to see from the
histogram that the empirical coefficient of 0:6 can be
generated by the model with irreversible investment. It is
less likely, however, that a coefficient of this size can be
generated by the model with large fixed costs. Less than
1% of the simulations produce coefficients below 0:2.
Intuitively, the leverage–profitability correlation is larger
for the case without fixed costs since investment options
are more valuable and leverage fluctuations are more
significant in the ‘‘inaction’’ region. When the alternative
definitions, pBW and pRZ , are used in the regressions, the
coefficients are larger in absolute value. For example, in
the fixed costs case, the profitability coefficient averages
2:76 under the pBW definition and 0:50 under the pRZ
definition.
It is easy to see the source of the negative correlation in
my model. Note that firm value is the sum of assets in
place V t and the value of growth options GOt . The leverage
ratio is the ratio of debt to the total value of assets:
Dt
LRt ¼ . (32)
V t þ GOt
Observe the effect of a positive profitability shock X t !
xX t ; x41 on the leverage ratio. The shock increases
revenues and debt proportionally. However, the value of
the option is more sensitive to the profitability shock. In
particular, it follows from Eqs. (3) and (12) that
Installed capital value V t ðxX t Þ ¼ xV t ðX t Þ,
Debt value Dt ðxX t Þ ¼ xDt ðX t Þ,
b
Growth options value GOt ðxX t ÞðxX t Þb ¼ x X bt . (33)
cross-sectional regression similar to the one used by
Fama and French (2002), using average leverage as a proxy
for the ‘‘target.’’ I include two control variables, cash flow
volatility ðsÞ and the elasticity of demand ðaÞ:
LRtþk
i  LRti ¼ b0 þ b1 LRti þ b2 LRi þ b3 si þ b4 ai þ e. (35)
Here LRi is the time-series mean of leverage, and ðLRitþk 
LRti Þ is the change in leverage from period t to period t þ k.
The negative coefficient b1 and positive coefficient b2
indicate a mean reversion. Table 4 summarizes the
findings: the first column is for k ¼ 10 (two and a half
years) and the last two columns are for k ¼ 5 and 20. The
regression coefficients consistently show evidence of
mean reversion. I find that the mean coefficient on lagged
leverage is 0:18 and 0:16 without and with fixed costs,
respectively. The coefficient on LRi for all cases and
horizons is similar in magnitude and opposite in sign.
I confirm that the simplified regression on the difference
ðLRti  LRi Þ produces a very close estimate of the coeffi-
cient. This means that the difference between past
leverage and its ‘‘target’’ has the most explanatory power
for the change in leverage. I investigate the mean
reversion of leverage at different horizons. The absolute
Table 4
Mean reversion tests
The leverage change is defined as the difference between leverage
ratios at time t þ k and t, LRtþk  LRt . Independent variables are the past
leverage ratio ðLRt Þ, the mean leverage ratio ðLRÞ, the volatility of cash
flows ðsÞ, and elasticity of demand ðaÞ. The base case is for k ¼ 10
(two and a half years); the last two columns display the results for
k ¼ 5 and 20. The t-statistics for simulations are calculated using the
Fama-MacBeth method. Coefficients and t-statistics are means over
1,000 independent simulations. Note that the number reported in
parentheses for the standard deviation column is the standard deviation
of the mean t-statistics across simulations. Panel A gives results for the
case without fixed costs, and Panel B offers corresponding results for the
case with fixed costs.
Summary k ¼ 10 Alternative horizons
Mean coeff. Std. dev. k¼5 k ¼ 20

Consequently, the leverage ratio declines with a positive Panel A—Zero fixed costs model
shock to profitability as long as the option is not Constant 0:005 0.004 0:003 0:012
ð3:31Þ ð2:41Þ ð2:39Þ ð5:69Þ
exercised:
Past leverage ratio LRt 0:181 0.010 0:090 0:343
xDt ð22:8Þ ð2:14Þ ð20:7Þ ð22:9Þ
LRt ðxX t Þ ¼ oLRt ðX t Þ. (34) Target leverage ratio LR 0.188 0.010 0.094 0.350
xV t þ xb GOt (22.0) (2.49) (2.05) (22.9)
Volatility s 0.005 0.007 0.003 0.016
When the firm invests (exercising the option), it issues
(1.97) (2.38) (1.76) (4.33)
new debt, and the relation between profitability and Elasticity a 0.028 0.007 0.013 0.070
leverage reverses. However, since most firms do not invest (8.04) (2.62) (4.61) (16.4)
at the same time, the first effect dominates in the cross
section. Panel B—Fixed costs model
Next, I follow Fama and French (2002) and Shyam- Constant 0:006 0.002 0.0001 0:013
Sunder and Myers (1999) and investigate whether ð4:54Þ (1.98) (0.346) ð8:08Þ
Past leverage ratio LRt 0:160 0.013 0:070 0:290
leverage is mean-reverting in the simulated panel of
ð30:8Þ (3.73) ð24:2Þ ð27:8Þ
firms. This empirical regularity is often seen as evidence Target leverage ratio LR 0.163 0.015 0.068 0.300
that management sporadically attempts to move the (28.1) (3.88) (21.2) (26.1)
leverage ratio back to some ‘‘target’’ once the benefit Volatility s 0.012 0.002 0.004 0.020
exceeds the financing costs. However, there are no (12.8) (3.52) (12.1) (16.8)
Elasticity a 0.009 0.004 0.005 0.007
financing frictions in my model since I allow for
(4.80) (2.21) (5.75) (3.34)
instantaneous and free leverage adjustment. I run a
 ARTICLE IN PRESS
248 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252

value of the coefficient decreases with horizon. For Table 5

example, I obtain coefficients 0:09 (no fixed costs) and Cross-sectional IDR tests
The implied debt ratio, IDRt;tþl , is defined as in Welch (2004) as the
0:07 (fixed costs) for k ¼ 10.
market leverage of the firm that does not adjust debt from period t to
The magnitude of the mean reversion coefficient falls period t þ l. That is, IDRt;tþl ¼ Dt =ðDt þ St ð1 þ r t;tþl ÞÞ. Here r t;tþl is the
within the bounds outlined in empirical studies. Fama and equity return for the period ðt; t þ lÞ. Horizon l is set to four quarters
French (2002) find that the coefficients range from 0:07 (1 year). Leverage LRtþl1
i is the market leverage ratio in the period
to 0:18 for different samples. Panel B of Fig. 5 provides immediately preceding ðt þ lÞ. The t-statistics for the simulations are
the distribution of the coefficients in simulated econo- calculated using the Fama-MacBeth method. Coefficients and t-statistics
are means over 1,000 independent simulations. Other columns display
mies. I find that my model can provide estimates that are
standard deviations for these values as well as 1%, 50%, and 99%
reasonably close to empirical values. percentiles across the simulations. Note that the number reported in
Mean reversion arises naturally because of fluctuations parentheses for the standard deviation column is the standard deviation
in the value of the firm. Low leverage is an indicator of a of the mean t-statistics across simulations. Panel A gives results for the
high ratio of growth options to assets in place. I argue that case without fixed costs, and Panel B offers corresponding results for the
case with fixed costs.
a low leverage ratio is more likely to increase than
decrease in the next instant. This is because positive Summary Percentile
shocks lead to exercise of the growth option and to
additional debt issuance, while negative shocks decrease Mean coeff. Std. dev. 1% 50% 99%
firm value.
Panel A—Zero fixed costs model
Finally, I show that in the simulated panel of firms, Constant 0.004 0.001 0.002 0.004 0.005
leverage depends on the history of the firm’s profitability. (8.00) (1.28) (5.26) (7.91) (11.5)
To investigate the relation between leverage and past IDRt;tþl
i
0.070 0.002 0.064 0.700 0.075
stock returns, I run a test similar to the one described in (82.1) (3.98) (71.6) (82.5) (90.7)
LRtþl1 0.882 0.004 0.872 0.882 0.891
Welch (2004): i
(170) (0.576) (169) (171) (172)
Volatility s 0:004 0.001 0:007 0:004 0:001
LRtþl
i ¼ b0 þ bl1 ðIDRt;tþl
i Þ þ b2 LRtþl1
i þ b3 si þ b4 ai þ e.
ð4:70Þ (1.44) ð7:81Þ ð4:79Þ ð1:02Þ
(36) Elasticity a 0:010 0.003 0:018 0:010 0:004
ð5:75Þ (1.61) ð10:0Þ ð5:69Þ ð2:16Þ
The implied debt ratio IDRt;tþl is defined similar to Welch
(2004) as the market leverage of a firm that makes no Panel B—Fixed costs model
attempts to adjust in response to equity shocks over l Constant 0.008 0.010 0.005 0.008 0.012
periods: (17.4) (0.001) (12.9) (17.7) (21.0)
IDRt;tþl
i
0.045 0.013 0.036 0.046 0.053
Dt (67.7) (0.002) (46.1) (64.4) (85.1)
IDRt;tþl ¼ . (37) LRtþl1 0.936 0.096 0.922 0.935 0.947
Dt þ St ð1 þ r t;tþl Þ i
(194) (0.001) (192) (194) (195)
Here, r t;tþl is the equity return for the period (t; t þ l). In Volatility s 0:006 0.008 0:012 0:006 0:003
ð15:7Þ (0.001) ð21:0Þ ð15:7Þ ð10:1Þ
the cross-sectional regression that controls for last
Elasticity a 0:006 0.013 0:013 0:006 0:003
quarter’s leverage, the IDRt;tþl variable should not have ð8:57Þ (0.002) ð14:2Þ ð8:21Þ ð4:44Þ
any impact on the firm’s present leverage ratio provided
that the firm adjusts often. However, I find that the
coefficient on the implied debt ratio is positive and in absolute value. Unlike the firms described in Welch
statistically significant in the regressions (see Table 5). It (2004) that are completely inactive, firms in my model do
averages 0:070 in the model with zero fixed costs and adjust their leverage in response to changes in equity
0:045 in the model with fixed costs for l ¼ 4 (1 year). value. But the optimal change in debt ignores the increase
Results are similar for other horizons. Welch (2004) in growth options. Therefore, the IDR variable can explain
reports a coefficient in the order of 1:0 for a 1-year only some of the variation in the simulated leverage
horizon. Note that including the book-to-market ratio in ratios.
the regression will not pick up all the variation in leverage. Table 6 explores the sensitivity of the regression results
I run the above test with the B=M ratio as a control and to the parameters used in the simulations. Recognizing
show that the results are qualitatively unchanged. The that the volatility parameters are likely to affect the
problem is that the B=M ratio cannot account for the ratio results through the value of parameter b, I first investigate
of the market value of growth options to the market value the effect of increasing by 20% or decreasing by 20% the
of assets in place. volatilities sm and si . Since these parameters are sampled
Why is lagged profitability affecting leverage and why from the empirically obtained sample, I increase or
is the effect smaller than in empirical findings? Lagged decrease all parameters in the sample and report the
profitability affects the number of growth options that are means of the resulting distributions in the table. Overall,
exercised and, therefore, determines current production the sensitivity of the cross-sectional regression coeffi-
capacity. For example, a formerly profitable firm experi- cients appears to be larger in the case with fixed costs. The
encing a negative shock will have a high leverage ratio profitability regression coefficient increases (in absolute
since it operates with excess capacity and the growth value) in the common and idiosyncratic components of
options are nearly worthless. It is not surprising, however, volatility. The coefficient on past leverage in the mean
that the size of the coefficients in my regression is smaller reversion test increases with volatility but exhibits less
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 249

Table 6 costs and irreversibility of capital investment. To abstract

Sensitivity of results to the parameters of simulations from existing theories resting on transaction costs, the
The definition of the regression coefficient bp is given in Table 3. The
model explicitly assumes free instantaneous capital
definition of bLR is given in Table 4. The definition of the coefficient
IDRt;tþ1 is given in Table 5. Comparative statics are conducted for the
structure rebalancing and then discusses the deviations
values of the key parameters: volatility, investment cost, and elasticity of from this assumption. The only MM assumption violated
demand. The numbers given in the ‘‘Value’’ column are means of the in the model is the existence of a tax benefit to debt.
respective parameter distribution. Each value in the distribution of Despite its parsimony, the model generates predictions
market volatilities, sm , and idiosyncratic volatility, si , is increased by
consistent with empirical facts. In the simulated economy,
20% (High s) or decreased by 20% (Low s). The values of the cost
parameter, P, are increased by 5 (High P) or decreased by 5 (Low P). The leverage is mean reverting, with gradual and lumpy
values of the demand elasticity parameter, a, are increased by 0.05 adjustments. Profitability is negatively correlated with
(High a) or decreased by 0.05 (Low a). Panel A gives results for the case leverage, and leverage depends on the path of past stock
without fixed costs, and Panel B offers corresponding results for the case returns.
with fixed costs.
I confirm this by running a number of capital struc-
Parameter Value Regression coefficients ture tests using model-generated data. I find that the
estimated coefficients are similar to results shown in
bp bLR IDRt;tþ1 the literature. It appears that the model without fixed
costs of investment (as opposed to the model with fixed
Panel A—Zero fixed costs model
Base 0.591 0.181 0.070 costs) does a better job of explaining the empirical data
High mean sm 0.130 0.692 0.199 0.070 since the size of the coefficients is closer to empirical
Low mean sm 0.090 0.497 0.178 0.070 estimates.
High mean si 0.286 0.627 0.184 0.071 The results in my paper, taken in conjunction with
Low meansi 0.199 0.564 0.175 0.068
High mean P 60 0.591 0.180 0.070
models emphasizing transaction costs, suggest that
Low mean P 50 0.594 0.181 0.070 structural models of financing decisions can indeed have
High mean a 0.2 0.575 0.180 0.078 significant predictive power. By ignoring real frictions, the
Low mean a 0.10 0.556 0.185 0.063 literature has perhaps understated the power of structural
models to resolve the ‘‘capital structure puzzles.’’
Panel B—Fixed costs model
Base 0.127 0.160 0.050
High mean sm 0.130 0.138 0.169 0.050
Low mean sm 0.090 0.123 0.159 0.048 Appendix A
High mean si 0.286 0.185 0.160 0.050
Low mean si 0.199 0.088 0.159 0.045
High mean P 60 0.124 0.154 0.045 A.1. Calculations for single option case
Low mean P 50 0.128 0.157 0.046
High mean a 0.2 0.181 0.161 0.065
Low mean a 0.10 0.070 0.160 0.030
Proof of Proposition 1. Let X  be the option exercise
trigger (i.e., the value of X t for which it is optimal to
exercise the growth option) and T I be the optimal
sensitivity. The IDR coefficient remains virtually un- stopping time when X t hits the trigger. X  will be
changed. The lower sensitivity can be explained by the determined endogenously. Calculate the first term in (7):
fact that volatility decreases the initial optimal capital and Z TI 
increases the investment thresholds. Therefore, firms start ð1  ti ÞEX t eð1ti Þrs X s K a0 ds
with lower leverage and can take longer to exercise their 0
Z 1 
options. The idiosyncratic component of volatility (which ¼ ð1  ti ÞEX t eð1ti Þrs X s K a0 ds ,
affects equally the demand shocks in the cross section) Z 10 
exhibits a larger effect on my results.  ð1  ti ÞEXt
eð1ti Þrs X s K a0 ds
I further study the effect of increasing or decreasing TI
the investment cost parameters, P, by 10% from the base ¼ VðX t ; K 0 Þ  VðX  ; K 0 ÞEX t ½eð1ti ÞrT I , (38)
mean of 50. Results in Table 6 indicate that decreasing the
cost of investment results in larger regression coefficients where VðX t ; K 0 Þ is the value of assets defined by (3). By an
since the value of options increases. Finally, I study the argument similar to that in Karatzas and Shreve (1991,
sensitivity of the results to the profit function. Increasing p. 197),
demand elasticity, a, to achieve the mean of 0.2 increases  b
(in absolute value) the regression coefficients. Larger Xt
EX t ½eð1ti ÞrT I  ¼ , (39)
values of a in the model imply that investment profit- X
ability is higher, therefore the value of growth options
increases. where b is defined above. Analogously,
Z 1 
6. Conclusion ð1  ti ÞEX t eð1ti Þrs X s K a1 ds
TI
 b
This paper develops a dynamic model of optimal  Xt
¼ VðX ; K 1 Þ , (40)
financial structure in the presence of real frictions: fixed X
 ARTICLE IN PRESS
250 Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252

and we obtain The explicit expression for BðKÞ is found by integrating

(48) on ½1; K or, equivalently, by integrating on ½K; 1
EI ðX t ; K 0 Þ
 b with a negative sign (note that ð1  aÞb  140 is required
Xt for convergence).
¼ EðX t ; K 0 Þ þ
X Z 1
 
BðKÞ ¼  B0K ðKÞ dK
 maxðVðX  ; K 1 Þ  PK 1 Þ  VðX  ; K 0 Þ K
K1  b  b1
að1  ti Þ K ða1Þbþ1 b1
¼ EðX t ; K 0 Þ ¼ .
|fflfflfflfflffl{zfflfflfflfflffl} bðrð1  ti Þ  mÞ ð1  aÞb  1 P
equity value of assets-in-place
  Finally, substitute BðKÞ into (47) to obtain the value of
Xt b

þ   ð1  aÞVðX  ; K 1 ðX  ÞÞ  VðX  ; K 0 Þ , (41) equity, including the value of assets in place (the first
X
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} term) and the value of the option to expand capacity (the
PV of the growth option
second term):
where we have used the FOC for K 1 ðX  Þ  b1
mX t K a0 b1
 
aVðX ; K 1 ðX ÞÞ ¼ K 1 ðX ÞP, 
(42) SðK; X t Þ ¼ þ
rðrð1  ti Þ  mÞ P
 b
 1=ð1aÞ að1  ti Þ K ða1Þbþ1
ð1  ti ÞaX   Xb. (50)
K 1 ðX  Þ ¼ , (43) bðrð1  ti Þ  mÞ ð1  aÞb  1 t
Pðrð1  ti Þ  mÞ
Investment is contingent on X t and is done in series of
and EðX t ; K 0 Þ is given by (5). The expression for capital (43)
small steps. The option value BðKÞX bt is, naturally, positive,
is identical to (8) given in the theorem. Finally, we choose
but its derivative, B0K ðKÞX bt , is negative, indicating that the
the investment trigger X  that maximizes the firm’s equity,
option becomes less valuable when the amount of capital
qEI ðX t ; K 0 jX t oX  Þ is increased. &
¼ 0. (44)
qX 
After substitution of (43), (41), and (3), the last expression A.3. Case with fixed costs
produces the investment threshold (10). Finally, substitut-
ing (10) and (43) into (41) produces (11). &
Proof of Proposition 3. Consider the following invest-
A.2. Incremental investment case ment strategy. Given initial K 0 and X 0 , firms increase
capital according to the recursive formula: capital is
increased to K Nþ1 ¼ dK N when the profitability shock
Proof of Proposition 2. The solution to (16) is reaches the respective threshold X Nþ1 ¼ gX N . Constant g
mK a X t maximizes the date zero equity value and d ¼ g1=ð1aÞ . The
EðK; X t Þ ¼ AX at þ BX bt þ  , (45) proof identifies the constant g and shows that, conditional
rð1  ti Þ  m r
on this investment strategy being followed in future
where ao0 and b41 solve the quadratic equation rounds, the firm will not deviate from following it in the
1 2 2 current round.
2s Y þ ðm  12s2 ÞY  rð1  ti Þ ¼ 0. (46)
Under the conjectured strategy, (23) is equivalent to
Unknown constants ðA; BÞ are determined by the appro- maximizing the present value of revenues net of invest-
priate boundary conditions. It follows from (19) that A ¼ 0 ment costs:
because ao0. Therefore, the solution in the ‘‘inaction’’ 8 9
region takes a form similar to the single option case: >
> >
>
>
< a >
=
X N K N ð1  ti Þ
mK a X t V N ðX N Þ ¼ max
KN > rð1  ti Þ  m
Rðg; dÞ  PK N Cðg; dÞ
|fflfflfflfflfflfflffl{zfflfflfflfflfflfflffl} >
,
EðK; X t Þ ¼ >
> >
ðrð1  ti Þ  mÞr : |fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} Present value of costs >
;
|fflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflffl} Present value of revenues
Value of assets in place
(51)
þ BðKÞX b . (47)
|fflfflffl{zfflfflffl}t where Rðg; dÞ and Cðg; dÞ are the revenue and cost multi-
Value of unexercised growth options
ples, respectively, that describe the value of embedded
Substituting (47) into (17) and (18) and solving the system growth options:
of two linear equations for two unknowns produces the
a a a
implicit expression for BðKÞ, Rðg; dÞ ¼ 1 þ g1b ðd  1Þ þ g22b d ðd  1Þ þ   
 b1 !b gb1  1
b1 ð1  ti ÞaK a1 ¼ ,
0
BK ðKÞ ¼  , (48) gb1  da
P bðrð1  ti Þ  mÞ 2
Cðg; dÞ ¼ 1 þ gb d þ g2b d þ   
and the expression for the investment threshold function 1
xðKÞ, ¼ . (52)
1  gb d
 
b ðrð1  ti Þ  mÞP For example, the first terms in Rðg; dÞ and Cðg; dÞ (which
xðKÞ ¼ . (49)
b  1 ð1  ti ÞaK a1 are both equal to one) represent, respectively, the value of
 ARTICLE IN PRESS
Y. Tserlukevich / Journal of Financial Economics 89 (2008) 232–252 251

assets in place immediately after the initial investment (56), we can write this maximization problem as
and the cost of making this investment. The second terms   
X N K aN ð1  ti Þ g1=ð1aÞb þ g1b m
in Rðg; dÞ and Cðg; dÞ represent, respectively, the increase in g ¼ arg max þ
g ðrð1  ti Þ  mÞ 1g 1=ð1 aÞb r
cash flows from exercising the first option and the cost of 
the exercise, etc. The first-order condition with respect to
g1=ð1aÞb
 PK N , (59)
1  g1=ð1aÞb
capital K N , applied to (51) produces
 1=ð1aÞ which, after substitution of (55), leads to (24) in the
X N Rðg; dÞað1  ti Þ
K N ðX N ; g; dÞ ¼ . (53) proposition. &
Pðrð1  ti Þ  mÞCðg; dÞ

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