Abstract
We relate the value of growth options in the firm's investment opportunity set to the level of debt in the firm's capital structure. Underinestment costs of debt increase and free cash flow benefits fall with additional growth options. Thus, if debt capacity is defined as the amount of debt the firm optimally adds for an incremental project, then the debt capacity of growth options is negative. This result implies that book leverage should fall with the addition of growth options. Our tests, using a large sample of industrial firms, confirm this prediction.
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