Risk Management and Real Options with Operating Hedging Contracts

Abstract

We analyze the optimal capacity investment (or operating leverage) and financial leverage policies with irreversible investment in the presence of financial distress and capacity expansion costs. In a loan market equilibrium with endogenous default, financial and operating leverage may either be substitutes or complements depending on the magnitude of expansion costs and whether the marginal tax rate exceeds marginal distress costs. Consequently, the relation of financial leverage and cash-flow uncertainty can be complex, consistent with empirical evidence. We generate novel predictions on the effects of financial and technological parameters on the cross-sectional variation in financial and operating leverage, and book-to-market.