*I would like to acknowledge financial support from the Social Science and Humanities Research Council of Canada.
Optimal Expansion Financing and Prior Financial Structure*
Article first published online: 2 MAR 2011
© 2011 The Author. International Review of Finance © International Review of Finance Ltd. 2011
International Review of Finance
Special Issue: FINANCING AND CAPITAL STRUCTURE: PART I
Volume 11, Issue 1, pages 57–86, March 2011
How to Cite
SARKAR, S. (2011), Optimal Expansion Financing and Prior Financial Structure. International Review of Finance, 11: 57–86. doi: 10.1111/j.1468-2443.2009.01099.x
- Issue published online: 2 MAR 2011
- Article first published online: 2 MAR 2011
This paper identifies jointly the optimal investment trigger and the optimal financing package for a corporate expansion project, using a real-option ‘trade-off’ model with agency problems. It also identifies the optimal initial capital structure of the firm (before the expansion). We show that it is generally optimal to use more debt than equity to finance the expansion. The other results are as follows: (i) existing debt has a negative effect, while the debt component of expansion financing has a positive effect, on investment; (ii) the debt component of the optimal expansion financing package is a decreasing function of the pre-expansion leverage ratio (consistent with mean reverting leverage ratios), and is also decreasing in the magnitude of the expansion opportunity; and (iii) the optimal pre-expansion leverage ratio is a decreasing function of both the firm's profitability and the magnitude of the growth opportunity. These relationships are generally consistent with empirical evidence, and help reconcile the trade-off theory of capital structure with apparently contradictory empirical evidence.