On the Interaction of Real and Financial Decisions of the Firm Under Uncertainty

Authors

  • AMIHUD DOTAN,

  • S. ABRAHAM RAVID

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    • Tel Aviv University and Haifa University, respectively. We thank the participants of seminars at New York University, CESA, Tel Aviv University, and Haifa University, especially Zvi Adar, Amir Barnea, Avraham Beja, Bernard Dumas, Avner Kalay, Kose John, and Marti Subrahmanyam for many helpful comments, ideas, and discussions. The revision was inspired by comments of participants in presentations in the Western Financial Association Meetings, 1984 and the European Financial Association Meetings, 1984, especially Robert Heinkel and Kose John. We also thank Dan Galai, Ivan Brick, and Brett Trueman. All remaining errors are, of course, our own.


ABSTRACT

This study analyzes the interaction between the optimal level of investment and debt financing. For this purpose, a model is structured in which a firm, facing an uncertain price, has to decide on its optimal level of investment and debt. The amount of investment sets a limit on output whose optimal level is determined after price is realized. The debt involved is risky (there exists a possibility of bankruptcy).

The analysis proves that investment and its optimal financing have to be simultaneously determined and that a negative relationship exists between operating and financial leverage. We also demonstrate that as the tax rate increases, optimal capacity decreases and optimal leverage increases. An analysis of the impact of changes in the expected price shows that under some conditions, an increase in expected price would lead to an increase in optimal investment (firm size) and a decrease in optimal debt.

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