Can Real Options Explain Financing Behavior?

Abstract

Dynamic structural trade-off models commonly invoke financial transactions costs in order to explain observed leverage fluctuations. This paper offers an alternative explanation for this pattern: real options. In the model, the only financial friction is a tax advantage to debt. However, the model incorporates two investment frictions: irreversibility and fixed costs of investment. Despite its parsimony, the model is broadly consistent with observed financing patterns. First, market leverage ratios are negatively related to profitability in the cross section. Second, leverage ratios in the simulated firms are mean-reverting and depend on past stock returns. Third, gradual and lumpy leverage adjustments occur in the absence of financial transactions costs. Fourth, debt tends to be the primary source of external financing for new investment. The predictive power of the model highlights the necessity of incorporating real frictions into structural models of corporate financing decisions.