Can real options explain financing behavior?

Research output: Contribution to journalArticle

38 Scopus citations

Abstract

Trade-off models commonly invoke financial transaction costs in order to explain observed leverage fluctuations. This paper offers an alternative explanation based on real options. The model is frictionless on the financing side but incorporates irreversibility and fixed costs of investment. Results obtained from simulating the model are broadly consistent with observed financing patterns. Market leverage ratios are negatively related to profitability, mean-reverting, and depend on past stock returns. The gradual and lumpy leverage adjustments can occur in the absence of financial transaction costs. This evidence shows that incorporating real frictions into structural models increases their explanatory power.

Original languageEnglish (US)
Pages (from-to)232-252
Number of pages21
JournalJournal of Financial Economics
Volume89
Issue number2
DOIs
StatePublished - Aug 1 2008
Externally publishedYes

Keywords

  • Capital structure
  • Corporate tax
  • Real options

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management

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