Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework




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    • Both authors are from the Graduate School of Business, University of Wisconsin-Madison. We are grateful to Phelim Boyle, Mark Flannery, Bjorn Flesaker, Rob Heinkel, Jim Hodder, Bob McDonald, John Parsons, Abraham Ravid, Mark Stohs, René Stulz (the editor), S. Venkataraman, and two anonymous referees for helpful comments. Paul Childs provided outstanding research assistance. Earlier versions of this article were presented at the 1992 European Finance Association meeting, the 1992 ORSA/TIMS meeting, the 1993 American Finance Association meeting, the 1993 Rutgers conference on optimal security design, the University of Florida, the University of Illinois, and the University of Wisconsin at Madison and Milwaukee. The second author gratefully acknowledges financial assistance from the Wisconsin Alumni Research Foundation.


This article analyzes the interaction between a firm's dynamic investment, operating, and financing decisions in a model with operating adjustment and recapitalization costs. Using numerical analysis, we solve the model for cases that highlight interaction effects. We find that higher production flexibility (due to lower costs of shutting down and reopening a production facility) enhances the firm's debt capacity, thereby increasing the net tax shield value of debt financing. While higher financial flexibility (resulting from lower recapitalization costs) has a similar effect, production flexibility and financial flexibility are, to some extent, substitutes. We find that the impact of debt financing on the firm's investment and operating decisions is economically insignificant.