Debt Overhang, Costly Expandability and Reversibility, and Optimal Financial Structure

This article compares the investment and financing decisions of a firm that adopts a ‘first-best’ strategy with those of a firm that adopts a ‘secondbest’ strategy. The former issues bonds upon deciding an initial capacity, while the latter issues bonds, and only then decides an initial capacity. The former is thus able to avoid the agency cost associated with the ‘debt overhang’ problem. Accordingly, the former will both issue more bonds and install a larger initial capacity than the latter. However, the agency cost of debt, i.e., firm value difference between these two strategies, is modest for plausible parameter values