Corporate borrowing and growth option value: The limited liability effect

Abstract

A firm issues bonds before undertaking a risky continuous investment project that is costly to later either expand or contract. The firm’s existing debt load causes it to install a smaller capacity because equity has limited liability. This lowers debt value, but such a cost should be borne by equityholders because debtholders will rationally anticipate equityholders’ future behavior. The firm’s choice of debt levels balances this agency cost against the tax shield benefit. As the firm incurs higher costs to later expand capacity, its growth option value becomes lower. The simulation results of this article are in line with Myers’ conjecture (1977), which states that a firm’s debt capacity is inversely related to its growth option value.