Essays on capital structure and investment

Thesis (Ph. D.)--University of Rochester. William E. Simon Graduate School of Business Administration, 2009.Chapter 1 presents a model of capital structure that endogenizes investment and financial policy and has fixed costs of recapitalization. The model reproduces known relations between firm size, leverage and growth opportunities. The model predicts that firms time capital structure adjustments to their target leverage ratios with the exercise of their growth options. Compared with growth firms, asset-in-place firms are more likely to recapitalize outside of large investment projects. More profitable firms have higher leverage. Firms facing low corporate tax rates choose not to issue any debt. Increases in volatility accelerate investment when volatility is high. Chapter 2 tests the model's predictions with respect to financial policy by identifying large investment projects in a sample of U.S. industrial firms. The tests support the model's predictions. I also find that growth and asset-in-place firms sequence equity issues before debt issues when they invest. This behavior mitigates the under-investment problem described in Myers (1977). The negative relation between profitability and leverage documented in earlier studies disappears by the end of the financing period of large investment projects. Growth firms substitute cash for external equity. In contrast, asset-in-place firms finance projects with equity to offset prior deviations above target leverage. These firms pay cash flow to shareholders and finance investment with external funds. These results are consistent with agency-theory explanations of payout policy in Rozeff (1982), Easterbrook (1984) and Jensen (1986). Dynamic trade-off models predict that firms let their leverage ratios vary within an optimal range. Chapter 3 estimates how the determinants of capital structure affect the two boundaries that define firms' optimal leverage ranges. Estimates of post- adjustment levels of leverage after a threshold has been reached show that, as predicted by trade-off theory, the relation between target leverage and profitability is positive. The results also imply that firms adjust to different target leverage levels depending on whether they reach an upper bound or a lower bound on their leverage range. This result, combined with the evidence in chapter 2, suggests that firms undertake asymmetric capital structure adjustments