Dynamic capital structure choice and investment timing

Abstract

The paper considers the problem of an investor that has the option to acquire a firm. Initially this firm is run as to maximize shareholder value, where the shareholders are risk averse. To do so it has to decide each time on investment and dividend levels. The firm’s capital stock can be financed by equity and debt, where less solvable firms pay a higher interest rate on debt. Revenue is stochastic.We find that the firm is run such that capital stock and dividends develop in a fixed proportion to the equity. In particular, it turns out that more dividends are paid if the economic environment is more uncertain. We also derive that the relationship between the levels of risk aversion of the current shareholders and the potential investor is a significant determinant in establishing whether the firm is a profitable takeover target for the investor.