Investment Frictions and Leverage Dynamics

Abstract

I examine the effect of investment frictions on leverage dynamics, using a model of the firm whose investments are 1) indivisible and lumpy, and 2) subject to time-to-build, which is a time lag between when investment expenditures are made and when the investment begins to generate cash. The firm dynamically chooses the timing of its investments and the source of investment funding and can endogenously adjust its capital structure. The model predicts that investment frictions can have significant impact on leverage fluctuations with only limited impact on long-term leverage means. Model simulations predict that a firm whose investments are lumpier and subject to longer time-to-build 1) has more volatile leverage target and realized leverage ratios, 2) has faster reversion to its target, and 3) funds its new incremental investments with a greater fraction of equity. The model also demonstrates that fluctuations in the target leverage ratio exhibit countercyclical behavior with equity returns where frictions amplify the countercyclical property of the target. Using data on selected firms in the oil and gas extraction industries, I find the evidence that smaller firms have more volatile investments and longer time-to-build, which may explain the observed differences in leverage dynamics across small and big firms. Regression analysis on the model-simulated data demonstrates that investment frictions can provide alternative interpretations of the empirical tests and some stylized facts documented in the recent empirical literature. For example, the investment frictions provide a rational explanation for why firms tend to raise equity following increases in their stock prices.