Financial leverage strategy with transaction costs

Abstract

This paper offers a class of diffusion models that mimic the firm's pecking order behaviour and are designed to optimize an intertemporal leverage strategy in the presence of refinancing transaction costs. The proposed class of models is compatible with traditional static tradeoff theories and can be used to recast those theories in a dynamic framework by superimposing refinancing costs. We derive analytical expressions for the parameters of an optimal leverage strategy with exogenous refinancing limits, including the minimum cost of capital in a stochastic dynamic framework with transaction costs, the target values to which the leverage should be readjusted when the limits are reached, and the mean leverage implied by the optimal strategy. Our class of models enriches the pecking order theory and provides a quantitative framework for its implementation as a decision tool. It also provides additional hypotheses for empirical validation of that theory. Symmetrically, our results show the importance of dynamic factors in designing and interpreting empirical tests of static tradeoff theories.