Optimal Expansion Financing and Prior Financial Structure

International Review of Finance, 11:1, 2011: pp.
57–86
DOI: 10.1111/j.1468-2443.2009.01099.x
Optimal Expansion Financing and

Prior Financial Structuren
SUDIPTO SARKAR
McMaster University, Hamilton, ON, Canada L8S 4M4
ABSTRACT
This paper identifies jointly the optimal investment trigger and the optimal
financing package for a corporate expansion project, using a real-option
‘trade-off’ model with agency problems. It also identifies the optimal initial
capital structure of the firm (before the expansion). We show that it is
generally optimal to use more debt than equity to finance the expansion.
The other results are as follows: (i) existing debt has a negative effect, while
the debt component of expansion financing has a positive effect, on
investment; (ii) the debt component of the optimal expansion financing
package is a decreasing function of the pre-expansion leverage ratio
(consistent with mean reverting leverage ratios), and is also decreasing in
the magnitude of the expansion opportunity; and (iii) the optimal pre-
expansion leverage ratio is a decreasing function of both the firm’s
profitability and the magnitude of the growth opportunity. These relation-
ships are generally consistent with empirical evidence, and help reconcile
the trade-off theory of capital structure with apparently contradictory
empirical evidence.
I. INTRODUCTION
What is the optimal combination of debt and equity for financing an expansion
project, and how does this combination depend, if at all, on the existing debt
level? This is an important question, since in recent years new investments have
been increasingly financed by external funds, both equity and debt (often in
combination); see Elsas et al. (2006), Gatchev et al. (2006), and Hovakimian
et al. (2001, 2004). This question is also of interest because investment and
financing decisions are often interdependent and cause conflicts of interest
(agency problems) between shareholders and bondholders. The major objective
of our paper is to identify the optimal combination of equity and debt to
finance an expansion project, for any given initial financial structure of the
firm.
n
I would like to acknowledge financial support from the Social Science and Humanities
Research Council of Canada.
r 2011 The Author. International Review of Finance r International Review of Finance Ltd. 2011. Published
by Blackwell Publishing Ltd., 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA
02148, USA.
International Review of Finance
We derive the optimal financing package, as well as the optimal investment

trigger, for an expansion project, using a structural real-option model in a
‘trade-off theory’ setting, similar to Mauer and Ott (2000). The model includes
the shareholder–bondholder agency problem in addition to traditional
financing factors such as taxes and bankruptcy costs. Although we make
certain simplifying assumptions (discussed in detail in Section IA), the model is
too complex to admit closed-form solutions. We therefore derive the results by
numerical methods, and repeat the computations with a wide range of
parameter values to ensure robustness of the results.
The optimal expansion financing package is derived from the usual tax–
bankruptcy–cost trade-off augmented by the agency problem of debt.
Additional debt helps shareholders because of the tax shield and the transfer
of wealth from bondholders to themselves, but also hurts them because of
higher expected bankruptcy costs; the optimal combination balances the two
effects. A large enough equity component in the expansion financing package
will give rise to underinvestment, and a large enough debt component will give
rise to overinvestment, relative to the first-best investment policy; thus, debt in
the expansion financing package has a positive effect on investment. Also, the
debt component generally exceeds the equity component in the optimal
expansion financing package, and is a decreasing function of the initial (pre-
expansion) leverage ratio and the magnitude of the expansion opportunity, and
an increasing function of project volatility and the cost of implementing the
expansion project.
The model also identifies the optimal initial leverage ratio (i.e., before
expansion), taking into account the expansion opportunity. This is done by
trading off the tax benefits of debt against the higher expected bankruptcy cost,
as well as the effect of debt financing on the future expansion project (because a
greater level of existing debt delays investment). It is shown that the optimal
pre-expansion leverage ratio is a decreasing function of the expansion scale and
the earnings level. The above results are generally consistent with empirical
evidence.
Recently, there have been a couple of papers that address the issue of
financing and investment decisions and their interactions. Tserlukevich (2008)
examines the financing of new irreversible investment when the only friction is
taxation, investment decisions are first-best, capital structure is adjusted
continuously, and debt is risk-free. His model generates implications consistent
with empirical regularities, e.g., a negative leverage–profitability relationship,
mean-reverting leverage ratios and path-dependent leverage ratios. Our model,
on the other hand, trades off the tax benefits of risky debt with the associated
bankruptcy costs and agency costs,1 when capital structure is adjusted at the
time of investment.
1 The two agency problems we focus on are underinvestment and overinvestment, originally
studied by Jensen and Meckling (1976), Myers (1977) and Stulz (1990). Please see Lyandres and
Zhdanov (2005) for a brief summary.
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58 International Review of Finance r International Review of Finance Ltd. 2011
Optimal Expansion Financing and Prior Financial Structure
Sundaresan and Wang (2006) study investment, financing and default

decisions in a model of sequential investment, and show that existing debt
distorts investment decisions, leverage ratio is negatively related to growth
opportunities, and the effect of debt seniority structure is significant only when
the debt is exogenous. In contrast, our model has equal-seniority debt and
focuses on explicitly characterizing the relative importance of debt and equity
in financing the expansion as well as before expansion.
The rest of the paper is organized as follows. Section I describes the model
and identifies the optimal investment trigger for a given expansion financing
package and initial financial structure. Section II identifies the optimal
expansion financing package for a given initial financial structure. Section III
computes the optimal pre-expansion leverage ratio, and Section IV concludes.
I. THE OPTIMAL EXPANSION DECISION FOR A SPECIFIED

FINANCING PACKAGE
A. The existing operations

Consider a firm with an existing production facility (assets-in-place), which
generates a stochastic stream of earnings (cash from operations) of $xt per unit
time. As in Goldstein et al. (2001), xt follows the lognormal process:
dx=x ¼ mdt þ sdz ð1Þ
under the risk-neutral probability measure. Here, m is the risk-neutral drift rate,
s the volatility, and dz the increment of a standard Weiner process. The
company also has an expansion opportunity, described in detail in Section IB
below.
The risk-free interest rate r is constant (we assume r4m, to ensure finite
values). There is an outstanding issue of perpetual debt,2 with a continuous
coupon of $c per unit time; the firm will make this coupon payment in
perpetuity unless it defaults on its debt. Following Mauer and Ott (2000),
Sundaresan and Wang (2006), etc., we assume that all free cash flows (x–c) are
paid out to shareholders as dividends. Then, if earnings fall below the coupon
obligation (xoc), equity holders inject the needed funds to service the debt,
provided it is in their interest to do so (Leland 1994). However, if x falls far
enough, the firm will default on its debt (this default trigger will be determined
optimally).3
2 The assumption of perpetual debt simplifies the analysis substantially without changing the key
economic insights.
3 In practice, the firm is likely to maintain a cash balance rather than pay out the entire free cash
flow, in order to make coupon payments in case of earnings shortfalls (xoc) or even to finance
the expansion. Thus, the firm could conserve some of its earnings in order to invest in the
expansion project. Alternatively, it could raise (at expansion) more than is necessary, in order to
protect against earnings shortfalls in future. Our model cannot determine which, if any, would
be the superior alternative, because we do not model the cash balance.
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International Review of Finance r International Review of Finance Ltd. 2011 59
The company faces a symmetric tax rate of t; thus the after-tax cash flow to
equity holders is (1–t)(x–c) per unit time.4 As in Leland (1994), t is interpreted as
the effective tax rate (or the tax advantage of debt, net of personal tax effects)
rather than the statutory tax rate.
At default, bondholders take over the firm’s assets, including the expansion
option, and incur a fractional bankruptcy cost of a1 for the tangible assets-in-
place and a2 for the intangible expansion option. We use different bankruptcy
costs because they tend to be higher for intangible assets than tangible assets
(Rajan and Zingales 1995; Berger et al. 1996); therefore, we expect 0a1a21.
At default, the payoff to equity holders is zero, and the payoff to bondholders is
(1–a1) times the value of the firm’s assets-in-place plus (1–a2) times the value of
the expansion option.5 Table 1 summarizes the notation used in the model.
In order to keep the model tractable, we have had to make some simplifying
assumptions. First, because we focus on expansion of existing operations, the
new project and the existing project are perfectly positively correlated. With
less-than-perfect correlation, the model would be substantially complicated by
the addition of multiple state variables; however, the basic conclusions should
not be very different. In any event, in practice the expansion decision is faced
frequently enough to make it important for managers. Second, factors not
considered here might have an impact on expansion financing, e.g., flotation
costs. If flotation costs make it impractical to issue small amounts of equity or
debt, the company might end up financing the expansion entirely with equity
or entirely with debt, instead of using the theoretical optimal combination
derived in our paper. Third, we assume that capital structure is adjusted only
when the expansion is implemented. This is a simplifying assumption similar to
other contingent-claim models, e.g., Childs et al. (2005) and Sundaresan and
Wang (2006). Strebulaev (2007) shows that, in the presence of transactions
costs, continuous adjustment is not optimal and firms will rebalance capital
structure only infrequently, at ‘refinancing points.’ Also, Flannery and Rangan
(2006), Faulkender et al. (2007), and Leary and Roberts (2005) show empirically
that adjustment costs cause rebalancing (if any) to be quite slow. Therefore, the
model would probably be more realistic with leverage rebalancing for
sufficiently large earnings shocks, e.g., increase debt when x rises, and reduce
debt when x falls, to some critical level, as in Fischer et al. (1989), Goldstein et
al. (2001), or Strebulaev (2007). However, these studies examine pure capital
structure changes without any investment decisions. Including these additional
boundaries would make our model intractable, and is beyond the scope of the
current paper; it is therefore left for future research.
4 Note that we ignore tax deductions arising from depreciation. The presence of a non-debt tax
shield such as depreciation would reduce the potential tax benefits of debt, hence the optimal
financing package would contain a smaller amount of debt than in our model.
5 As is common in the contingent-claims literature (e.g., Leland 1994), the model rules out
issuance of debt after bankruptcy reorganization.
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Table 1 Notation used in the model

xt Earnings per unit time
s Volatility of earnings stream
c Pre-expansion coupon, $ per unit time
a1 Fractional bankruptcy costs for existing assets
a2 Fractional bankruptcy costs for expansion option
p Fractional increase in coupon at expansion
g1 Positive exponent in valuation formulas
m Coverage ratio multiplier at expansion
xn Optimal expansion trigger
F(x) Post-expansion debt value
D(x) Pre-expansion debt value
m Drift rate of earnings stream
r Risk-free interest rate
t Effective tax rate
y Expansion scale
I Investment required for expansion
K Amount of debt issued at expansion
g2 Negative exponent in valuation formulas
x0 Pre-expansion default trigger
xF First-best expansion trigger
G(x) Post-expansion equity value
E(x) Pre-expansion equity value
B. The expansion option

The firm has the option to expand the scale of operations by a factor of y, i.e., to
increase earnings from $x to $(11y)x per unit time.6 The cost involved in
implementing this expansion (or exercise price of the expansion option) is $I.
The expansion is financed by a package consisting of additional equal-seniority
debt and additional equity if necessary, both issued at a fair price. The new debt
will increase the coupon by a factor of p, i.e., the coupon will increase from c to
(11p)c at expansion. If the new debt is worth less than $I, the remaining
amount is raised by issuing equity. The composition of this expansion financing
package will be optimally determined in our model.
Once the firm exercises the expansion option, it is prohibitively expensive to
switch back to the pre-expansion scale of operations. If the firm defaults before
expansion, the bondholders will acquire the growth option along with the
firm’s tangible assets (but with different bankruptcy costs, as explained above).
6 We assume that the expansion project is implemented instantaneously, as in Mauer and Ott
(2000), Sundaresan and Wang (2006), etc. Tsyplakov (2008) examines the financing decision
when there is a time-to-build lag, and shows that such a lag will favor equity financing, because
additional earnings (which could be sheltered from taxation) will not start right away. Thus, the
effect of time-to-build would be to increase the relative importance of equity in the optimal
expansion financing package.
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In this setting, the optimal investment policy is to expand as soon as x rises

to some critical level (Dixit and Pindyck 1994; Carlson et al. 2004). Consistent
with the existing literature (Mauer and Ott 2000; Childs et al. 2005; Lyandres
and Zhdanov 2005, etc.), we assume that the manager’s objective is to maximize
equity value, because the manager is employed by the shareholders. This
optimal or equity-value-maximizing policy is usually referred to as the second-
best policy. We also look at the first-best policy (which maximizes the total firm
value, i.e., equity plus debt), because it is the standard benchmark in the
literature. As in the existing literature (Mauer and Ott 2001; Childs et al. 2005),
a higher first-best expansion trigger implies overinvestment, and a lower first-
best expansion trigger implies underinvestment.
C. Valuing the post-expansion securities

After the expansion, the earnings stream is (11y)x where x follows the
stochastic process (1), and the coupon stream is (11p)c. Thus, at expansion, the
interest coverage ratio changes from x/c to mx/c, where m5(11y)/(11p) is
termed the coverage ratio multiple.
As shown in Appendix A, the post-expansion debt and equity values are
given by
g2
c ð1 a1 Þð1 tÞ x
Debt : FðxÞ ¼ ð1 þ pÞ 1 1 ð2Þ
r ð1 1=g2 Þ xD
g2
mx c c=r x
Equity : GðxÞ ¼ ð1 tÞð1 þ pÞ þ ð3Þ
r m r ð1 g2 Þ xD
where xD is the optimal default trigger, given by
cð1 m=rÞ
xD ¼ ð4Þ
mð1 1=g2 Þ
and g1 and g2 are the positive and negative roots, respectively, of the quadratic
equation
0:5s2 gðg 1Þ þ mg r ¼ 0 ð5Þ
and are given by
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
g1 ¼ 0:5 m=s2 þ 2r=s2 þ ð0:5 m=s2 Þ2 ð6Þ
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
g2 ¼ 0:5 m=s 2r=s2 þ ð0:5 m=s2 Þ2
2
ð7Þ
The interpretation of debt and equity value (equations 2 and 3) is
straightforward. For debt, the term (11p)c/r represents the value of a ‘no-
default’ version of the bond, and the second term within curly brackets
represents the reduction in value because of default risk. For equity, the first two
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terms within curly brackets represent the value of operating the company
forever, and the third term represents the value of the option to default. Note
that a2 does not appear in the debt and equity valuation formulas. This is
because, once the expansion option has been exercised, all assets are in place;
hence the smaller bankruptcy cost (a1) will apply to all assets, and the larger
bankruptcy cost of the expansion option (a2) will no longer be relevant. Note
also that the expansion scale (y) enters the equity value via the multiple ‘m,’ as
well as indirectly through the default threshold xD, while only the latter effect is
present in the case of debt value.
D. Financing the expansion

The expansion will be financed partly by equal-seniority debt and partly by
equity,7 and the coupon will rise from $c to $(11p)c per unit time. If the
additional debt falls short of $I, the shortfall will be met by equity holders; if it
exceeds $I, the excess amount will be paid to the shareholders as a special one-
time dividend. All-equity expansion financing implies p50, and all-debt
financing requires that the value of the new debt be at least $I.
Because the new debt is of equal seniority as the old debt, the new
bondholders will own a fraction p/(11p) of the total debt after expansion. As in
Kim and Maksimovic (1990), Mauer and Sarkar (2005), etc., we assume that,
before exercising the expansion option, the firm finalizes the terms of the debt
issue, specifically the additional coupon (pc) and the amount of new debt (say
$K). However, rational bondholders will not agree to a contract allowing the
firm to borrow $K unless it is a fair price for the debt. Because bondholders
cannot force shareholders to choose a particular exercise policy, they will value
the debt (and thereby determine K) under the assumption that the ex-post
exercise policy will maximize equity value. Thus, K must equal the value of the
debt issued at the equity-value-maximizing expansion trigger (say xn), i.e., a
fraction p/(11p) of the total post-expansion debt, F(xn). Clearly, K5[p/
(11p)]F(xn) is the incentive-compatible debt value, i.e., the only value of K
that will be acceptable to the bondholders, given their expectations regarding
firm behavior and the non-contractibility of investment policy.
7 We assume equal-seniority debt for reasons of tractability. The company could of course issue
higher-seniority or lower-seniority debt. However, higher-seniority debt is generally ruled out by
protective covenants (Nash et al. 2003), hence it is not of much practical interest. With junior
debt, there would be two effects: (i) the underinvestment incentive would increase (in fact, Myers
1977 suggests equal-seniority debt as a way to mitigate underinvestment), and (ii) it will be more
difficult to transfer wealth from existing (senior) debt holders, and the expansion financing
decision will therefore more closely resemble an independent or ‘stand-alone’ financing
decision. Thus, we can expect the optimal expansion debt component to be smaller (see Section
II.C for stand-alone project); also, the optimal expansion financing package should be less
sensitive to the initial debt level (this is confirmed by Sundaresan and Wang 2006).
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E. Valuing the pre-expansion securities

As shown in Appendix B, the pre-expansion debt and equity values are given by
Debt : DðxÞ ¼ c=r þ D1 xg2 þ D2 xg1 ð8Þ

x c
Equity : EðxÞ ¼ ð1 tÞ þ E1 xg2 þ E2 xg1 ð9Þ
rm r
where D1, D2, E1, and E2 are constants to be determined from the boundary
conditions. In equation (8), c/r represents the value of a ‘no-default’ bond, and
the other two terms represent the possibility of default and the possibility of
expansion. For equity (equation 9), the first term represents the value of
operating forever (in the absence of default and expansion options), and the
other two terms represent the values of the option to default and the option to
expand.
i. Boundary conditions
Before expansion, there are two boundaries, the lower boundary at which the
firm defaults (say x5x0) and the upper boundary at which the firm expands (say
x5xn). The boundary conditions for debt and equity are given below.
Debt: When the company defaults, bondholders take over the assets of the
firm, but incur bankruptcy costs of a1 for the assets-in-place and a2 for the
growth option. The value of the assets-in-place, i.e., the unlevered firm value, is
(1–t)x0/(r–m) at default, while the value of the expansion option at default
h ig
I ð1tÞyx0 ð11=g1 Þ 1
(derived in Appendix C) is ðg 1Þ IðrmÞ .
1
Thus, the first boundary condition is

ð1 tÞx0 I ð1 tÞyx0 ð1 1=g1 Þ g1
Dðx0 Þ ¼ ð1 a1 Þ þ ð1 a2 Þ ð10Þ
ðr mÞ ðg1 1Þ Iðr mÞ
At the expansion boundary, the value of the pre-expansion debt is simply the
old debt holders’ portion of the total (post-expansion) debt, i.e., a fraction
1/(11p) of F(xn):
1
Dðx Þ ¼ Fðx Þ ð11Þ
ð1 þ pÞ
Equations (10) and (11) can be solved for the constants D1 and D2 in terms of
the two triggers x0 and xn, which will be derived below.
Equity: At the lower boundary (x5x0), the payoff to equity holders is zero:

x0 c
Eðx0 Þ ¼ ð1 tÞ þ E1 ðx0 Þg2 þ E2 ðx0 Þg1 ¼ 0 ð12Þ
ðr mÞ r
At the upper boundary (x5xn), the payoff to equity holders is the post-
expansion equity value, i.e., G(xn), less the investment made by the equity
holders, i.e., $(IK), where $I is the amount needed for the expansion and $K is
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the amount raised by issuing new debt. Thus, the upper boundary condition is
Eðx Þ ¼ Gðx Þ ðI KÞ
From Section ID, we have

p
K¼ Fðx Þ:
1þp
Substituting for E(xn), G(xn), and K, we get

x c
ð1 tÞ þ E1 ðx Þg2 þ E2 ðx Þg1 ¼
ðr mÞ r
g2
mx c c x
ð1 tÞð1 þ pÞ þ ð13Þ
ðr mÞ r rð1 g2 Þ xD

pc ð1 a1 Þð1 tÞ x g2
þ 1 1 I
r 1 1=g2 xD
For the two triggers x0 and xn to be optimal (i.e., equity-value-maximizing),
they must satisfy the smooth-pasting conditions, which equate the derivative of
the equity value at default (expansion) to the derivative of the payoff at default
(expansion); see Leland (1994). Since the payoff to equity holders is zero at
default, the smooth-pasting condition for the default trigger is dE
dx x¼x0 ¼ 0, or
ð1 tÞx0
þ E1 g2 ðx0 Þg2 þ E2 g1 ðx0 Þg1 ¼ 0 ð14Þ
ðr mÞ
Similarly, the smooth-pasting condition for the expansion trigger is

dE
¼ G0 ðx Þ;
dx x¼x
or:
ð1 tÞx
þ E1 g2 ðx Þg2 þ E2 g1 ðx Þg1 ¼ ð1 tÞð1
ðr mÞ
g 2
mx c=r x
þ pÞ ð15Þ
ðr mÞ ð1 1=g2 Þ xD
Equations (12)–(15) can be solved for the two constants E1 and E2 and the
two optimal triggers x0 and xn. The expansion trigger xn represents the optimal
(equity-value-maximizing or second-best) expansion policy. Once the constants
E1 and E2 are determined, the equity value can be computed for any given x.
F. Illustration
There is no analytical expression for the optimal expansion trigger xn. We
therefore illustrate its behavior by numerically solving equations (12)–(15) for
various expansion financing packages (i.e., various values of p or m). The
following ‘base case’ parameter values are used for the computations: I510,
r56%, m50, s515%, c50.6, t515%, a150.25, a250.5, and y51. The base case
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values have been chosen to be reasonable (see, for instance, Leland 1994).
However, to ensure that the results are robust to the choice of parameter values,
all the results of the paper are derived for a wide range of parameter values.
With these parameter values, if the coverage ratio is kept unchanged (m51,
or p51), we get the following outputs from the model: the optimal default
trigger is x050.3587, optimal expansion trigger xn50.9325; and new debt issued
K58.8441. The procedure is repeated for various financing packages (p or m),
and the optimal expansion trigger is shown as a function of the expansion
financing package m in Figure 1 [the thick black line with the caption ‘Optimal
(base case)’].
It is clear that financing and investment decisions are interrelated. We note
that xn is an increasing function of m (or a decreasing function of p); thus, using
more debt in the expansion financing package will lower the optimal expansion
trigger or bring it closer, thereby making expansion more likely. Therefore, debt
in the expansion financing package will have a positive effect on investment.
This is consistent with the empirical results of Lyandres and Zhdanov (2005),
who find a positive relationship between debt issuance and investment.
In this section, we have identified the optimal expansion trigger for any
given expansion financing package m and initial debt level c. This would be
useful to know if exogenous constraints compelled the company to use a certain
1.2
1.1
Optimal (base case)
Expansion trigger
FB (base case)
1
0.9 FB (frictionless)
Optimal
(frictionless)
0.8
0.7
0.9 1 1.1 1.2 1.3 1.4 1.5
m (Coverage ratio multiplier)
Figure 1 Optimal and First-Best (FB) Investment Triggers (xn and xF Respectively) as
Functions of the Expansion Financing Package (m).
The Base Case Parameter Values are I510, r56%, m50, s515%, c50.6, t515%, a150.25,
a250.5, and y51. ‘Frictionless’ Means a World with No Taxes or Bankruptcy Costs (i.e.,
t5a15a250), but the Other Parameter Values are the Same as the Base Case. The Vertical
Line Shows mF, the Coverage Ratio Multiple That Ensures That the Optimal Trigger is
also the First-Best, Thereby Eliminating Underinvestment and Overinvestment. In Both
Cases, mF51.2012.
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financing package for the expansion. In such situations, our model could be
used to decide the optimal expansion trigger. For instance, if the company was
not allowed to issue debt for the expansion (say, because of a covenant), then
the expansion financing package would be given by p50 or m52; and the
(constrained) optimal expansion trigger xn would be significantly higher at
1.1321; this illustrates the underinvestment effect of Myers (1977).
G. Comparison of optimal and first-best expansion triggers

The first-best expansion trigger xF maximizes the total firm value (debt plus
equity). Thus, the appropriate smooth-pasting condition will be

dE dD
þ ¼ G0 ðxF Þ þ F0 ðxF Þ
dx F dx F
x¼x x¼x
F
We derive x basically to use as a benchmark for comparison with the optimal
trigger xn, because discussions of underinvestment/overinvestment are based on
a comparison of xn and xF (Mauer and Ott 2000; Childs et al. 2005; Lyandres and
Zhdanov 2005).
Underinvestment and Overinvestment: The two types of agency problems in our
model are underinvestment and overinvestment. Underinvestment is widely
discussed in the literature (Myers 1977; Mauer and Ott 2000; Sundaresan and
Wang 2006, etc.). Certain types of overinvestment have been discussed in the
literature (see, Lyandres and Zhdanov 2005, for a summary). However, the
overinvestment in our model is different from the traditional explanations, and
can be explained as follows. A company has assets-in-place and a growth
option. Shareholders will lose both these at default, whether default occurs
before or after expansion. However, if the expansion is financed even partly
with debt, and expansion occurs before default, then shareholders would have
received the proceeds from the new debt (this would not be true if the
expansion is all-equity-financed). Therefore, with partial debt financing of the
expansion, if default occurs before expansion shareholders get nothing from
the expansion option, whereas if expansion occurs before default they get the
proceeds form the new bond issue. Thus, shareholders have an incentive to
invest early, or overinvest, when the expansion is financed with debt, and the
larger the debt component the greater the overinvestment incentive.8
Using the same base case parameter values as in Section IF, along with p51,
we get an expansion trigger of xF51.02, and a new debt issue of K59.022. Figure
1 also shows xF as a function of m, for the base case as well as a frictionless world
(t5a15a250), which is the setting of Lyandres and Zhdanov (2005).
8 Note that this overinvestment is relevant when the manager’s objective is to maximize equity
value, and is different from the well-known overinvestment incentive resulting from managerial
entrenchment (Stulz 1990) – in a firm with atomistic shareholders where the manager derives
benefits from all investments, he will tend to overinvest even if shareholders do not benefit from
the projects. Out model does not address this type of overinvestment, because we assume
managers maximize equity value.
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We first note that, in a frictionless world, xF is independent of expansion

financing, as expected. Second, for all-equity financing (p50), we note that
xn4xF, which implies underinvestment; this is the well-known debt overhang
problem (Myers 1977). As the debt component p is increased, the degree of
underinvestment declines; for a certain value of p, the two triggers are exactly
equal, xn5xF;9 and for larger debt components the relationship is reversed,
xnoxF, denoting overinvestment. Thus, a large equity component in the
expansion financing package results in underinvestment, while a large debt
component results in overinvestment. This result follows from the discussion
above. The relationship between expansion financing and underinvestment/
overinvestment is summarized in
i. Result 1
A ‘large enough’ equity component in the expansion financing package will result
in underinvestment, and a large enough debt component will result in
overinvestment. An appropriate combination of debt and equity financing will
eliminate both underinvestment and overinvestment, thereby ensuring a first-
best investment trigger.10
Therefore, when to invest, and whether there will be underinvestment or

overinvestment, depends on the expansion financing package. It is possible to
ensure a first-best investment policy by choosing an expansion financing
package such that xn5xF. However, in the presence of tax and bankruptcy costs,
this expansion financing policy will generally not maximize equity value and
will therefore not be optimal.11 Therefore, in the rest of the paper, we will not
focus on this issue, because we are interested in optimal or equity-value-
maximizing expansion financing.
II. THE OPTIMAL EXPANSION FINANCING PACKAGE
In this section, we address the most important question in the paper: how
should the expansion project be financed? That is, what proportions of the
9 In this example, the expansion financing package that eliminates underinvestment and
overinvestment (in both cases, i.e., base case and frictionless world) is given by p50.665 (or
m51.2012); this is identified numerically. This package is independent of the ‘friction’
parameters (t, a1, and a2).
10 Note that this result is valid for the under- and over-investment resulting from the shareholder–
bondholder agency problem, but does not apply to the manager–shareholder agency problem
described by Stulz (1990).
11 The financing decision is driven by the trade-off between debt tax shields and bankruptcy and
agency costs of debt. Therefore, minimizing or eliminating just the agency cost (by ensuring
xn5xF) is not necessarily optimal because it would ignore the effects of taxes and bankruptcy
costs.
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investment cost $I should be raised in the form of equity and debt? The
objective, as usual, will be to maximize shareholders wealth.
A. Expansion financing and equity value

The expansion financing package can be parsimoniously represented by the
multiple m. The optimal expansion financing package mn will maximize the
pre-expansion equity value E(x):12
m ¼ arg max Eðx; mÞ ð16Þ
m
There is no analytical solution to equation (16), hence mn has to be identified

numerically. In order to ensure the robustness of our results, the numerical
computations were repeated with a wide range of parameter value combina-
tions. The results of this section were found to be valid for the entire range.
If the debt component of the expansion financing package is increased,
current equity holders are affected in two ways:
Positively: they benefit (i) from the additional tax shield from the new
debt, and (ii) because the more new debt used, the greater the wealth
they can transfer from old bondholders to themselves; in fact, too
small a new debt component will result in wealth transfer in the
opposite direction.
Negatively: because the post-expansion default trigger would be higher,
resulting in a higher probability of default or earlier default, which
implies higher expected bankruptcy costs. This will hurt shareholders,
because the new debt is issued at the fair price, hence shareholders bear
the loss in value associated with higher-expected bankruptcy costs.
The negative effect will initially be small, hence the positive effect will
dominate and current equity holders will on balance benefit from a larger debt
component (smaller m). Thus, equity value should initially be an increasing
function of the new debt component. However, when the new debt component
exceeds a certain level, default risk becomes important and the negative effect
dominates, hence equity value should be decreasing in the new debt
component. As a result, we get an inverted U-shaped relationship between
the equity value E(x) and m, and this allows us to identify the unique optimal
expansion financing package mn.
B. The base case

Figure 2 shows E(x) as a function of m, for different values of x, using the same
‘base case’ parameter values as in Section IF. As expected, E(x) is initially
12 Because this equity value will also depend on how the expansion is financed (i.e., on the
parameter m), we can write it as E(x,m).
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4
Equity Value x = 0.7
x = 0.6
2
1
x = 0.5
0
0.6 0.8 1 1.2 1.4
m (Coverage ratio multiple)
Figure 2 Equity Value as a Function of the Expansion Financing Package (m), for
Three Earnings Levels. The Vertical Line Shows the Expansion Financing Package That
Maximizes the Equity Value (mn50.9330), which is Independent of x.
The Base Case Parameter Values are I510, r56%, m50, s515%, c50.6, t515%, a150.25,
a250.5, and y51.
increasing and subsequently decreasing in m. In all cases, irrespective of the

value of x, equity value is maximized at mn50.9330 (pn51.1437). This indicates
that the optimal expansion financing package is independent of the state
variable x, which has the desirable implication that the optimal expansion
financing package is time-independent, i.e., does not change over time as x
changes randomly. The other outputs are: x050.3585, xn50.9008, and new debt
K59.8325; thus the expansion will be financed by 98% debt. Also, the first-best
expansion trigger is xF51.0319, which indicates overinvestment (since xF4xn).
Thus, a firm following the equity-value-maximizing or optimal policy will
issue $9.8325 of new debt and $0.1675 of new equity, and invest the $10 in the
expansion project, when x rises to 0.9008. The additional coupon upon
expansion can be computed from pn: the coupon rises by $0.6862 (114.37% of
0.6). The equity value (that is being maximized here) will of course be a
function of x. For x50.5, 0.6, and 0.7, the equity values under optimal
expansion financing come to $0.9873, 2.4032, and 4.1832, respectively.
In this section, we have determined the optimal expansion financing
package for any given (not necessarily optimal) initial leverage ratio. This
analysis is useful because the company might not be at its optimal financial
structure when the expansion decision is made, because continuous leverage
adjustments are ruled out by adjustment costs. However, because companies
might presumably have the ability to also choose the pre-expansion leverage
ratio, Section III looks at how to do it optimally.
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C. Optimal financing for a stand-alone expansion project

In Section IIA, we discussed how the current equity holders are affected by the
debt component of the expansion financing package. The argument is similar
to the traditional tax–bankruptcy cost trade-off theory, except for point (ii)
under positively, which captures the shareholder–bondholder agency problem
inherent in the expansion decision. Thus, as explained in point (ii), there is an
additional positive effect of expansion debt, relative to the traditional tax–
bankruptcy cost trade-off. Existing debt allows the transfer of wealth from
bondholders to shareholders, and this must be taken into consideration along
with the traditional factors, tax and bankruptcy cost. Note that this agency
problem is a factor only in the case of an expansion of existing operations and
not for new operations, hence the existing financial structure makes a
difference in our model. If it were a new venture or a stand-alone project
separate financially from the rest of the company, this effect would not be
relevant.
How large is this new (agency) effect on optimal expansion financing? In
order to answer this question, we computed the optimal debt–equity
combination for the expansion project if it were viewed as a separate stand-
alone entity, unrelated to the existing operations, assuming that the expansion
takes place at the same trigger xn as in Section IIB. Using the method of Leland
(1994), it can be shown that the optimal debt level for the stand-alone project
(from the trade-off theory) is given by13

yx ð1 1=g2 Þ g2 ð1 a1 Þð1 tÞ þ t g2 1=g2
cst ¼ ð17Þ
ð1 m=rÞ t
and the corresponding amount of debt is

g2
cst cst ð1 a1 Þð1 tÞ x
Kst ¼ 1 ð18Þ
r r ð1 1=g2 Þ xDst
st ð1m=rÞ
where xDst ¼ cyð11=g . This debt amount can be compared with the optimal
2Þ
expansion debt from Section IIB.
Using the same base case parameter values as in Section IIB, we get the level
of debt Kst58.2556. Recall that the optimal debt amount for the expansion
(from Section IIB) was K59.8325. Thus, the agency problem associated with
existing debt has a significant effect on optimal expansion debt, increasing it by
about 19% relative to the tax–bankruptcy cost trade-off, in the base case. We
find that this agency effect is generally quite significant for various parameter
value combinations.
We also find that this ‘agency’ incentive (to use more debt to finance the
expansion) increases with the initial debt level. Clearly, the agency effect works
in the opposite direction to the traditional trade-off theory, in which a higher
initial debt level leads to reduced debt usage for the expansion.
13 The complete derivation is available from the author on request.
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D. Optimal expansion financing in the presence of constraints

The approach of Section IIA. can also be used to identify the best expansion
financing package when the firm is subject to constraints or covenants. From
the resulting equity values, we can measure the loss to shareholders from not
following the unconstrained optimal policy; in other words, we can quantify
the cost of a covenant.
For instance, if there is a covenant that states the interest coverage ratio
cannot be allowed to fall at expansion, i.e., m1 (or py), then the above
numerical solution can be used to identify the (constrained) optimal financing
package, which turns out to be x050.3587, xn50.9325, and new debt K58.8441;
and the resulting equity value is 0.9826, 2.3942, and 4.1685 for x50.5, 0.6, and
0.7, respectively. Clearly, this is sub-optimal, even though the losses are not
large (0.47, 0.37, and 0.35%, respectively, relative to equity values with
unconstrained financing computed in Section IIB).
Another example is a covenant that rules out future debt issues, i.e., p50, or
m5(11y), which implies the expansion has to be financed entirely with equity.
In this case, the solution to the constrained optimization problem is x050.3642,
xn51.1321, and new debt K50; with a resulting equity value of 0.8663, 2.1671,
and 3.7970 for x50.5, 0.6, and 0.7, respectively. The loss to shareholders,
relative to the unconstrained case, works out to 12.25, 9.83, and 9.23%; clearly,
these losses are quite significant. Thus, the ability to issue debt to finance future
expansions can be valuable, and it is not surprising that covenants that rule out
all future debt issues are very rare (Mauer and Ott 2000), and that companies
routinely maintain unused debt capacity or financial slack, which gives them
the flexibility to issue more debt for new investments and not have to rely on
equity financing.
It should be pointed out that the cost of a covenant, as illustrated above,
captures the ex-post effect, i.e., the loss to shareholders caused by the covenant
after the old debt is already in place. However, because of the protective nature
of the covenant, the price of the pre-expansion debt would be higher (raising
the proceeds from the debt issue). Also, because of the covenant, the firm would
probably find it optimal to issue more pre-expansion debt. Thus, the ex-ante cost
of the covenant would be lower, as illustrated in Section IIIB.
E. Properties of the optimal expansion financing package

We now turn to the comparative static properties of the optimal expansion
financing package. Table 2 summarizes the results over a wide range of
parameter value combinations. The results for m and r are not reported because
they are as expected and not particularly interesting, but they are available on
request from the author; further, the results are independent of a2, which is
therefore also excluded. The table shows the details of the optimal expansion
financing package (pn and K/I), as well as the optimal default trigger (x0),
optimal expansion trigger (xn) and first-best expansion trigger (xF).
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Table 2 Comparative static results for optimal expansion financing
c pn x0 xn xF K/I (%) y pn x0 xn xF K/I (%)
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0.2 4.123 0.1283 0.8603 0.9763 123.68 0.6 1.380 0.3807 1.3867 1.6660 122.04
0.4 1.852 0.2485 0.8730 1.0104 108.78 0.8 1.229 0.3720 1.0871 1.2767 107.01
0.6 1.144 0.3585 0.9008 1.0319 98.33 1.0 1.144 0.3585 0.9008 1.0319 98.33
0.8 0.824 0.4596 0.9420 1.0437 91.93 1.2 1.092 0.3442 0.7735 0.8638 92.92
1.0 0.652 0.5538 0.9926 1.0481 88.39 1.4 1.059 0.3291 0.6806 0.7414 89.36
I pn x0 xn xF K/I (%) z pn x0 xn xF K/I (%)
8 0.885 0.3480 0.7446 0.8332 93.21 0.05 0.969 0.5070 0.7180 0.7433 92.03
9 1.012 0.3538 0.8219 0.9331 95.82 0.10 1.057 0.4262 0.8090 0.8847 95.37
10 1.144 0.3585 0.9008 1.0319 98.33 0.15 1.144 0.3585 0.9008 1.0319 98.33
11 1.280 0.3624 0.9809 1.1299 100.74 0.20 1.232 0.3022 0.9997 1.1921 100.95
12 1.419 0.3657 1.0621 1.2271 102.96 0.25 1.323 0.2556 1.1088 1.3684 103.29
t pn x0 xn xF K/I (%) a1 pn x0 xn xF K/I (%)
0.05 0.977 0.3577 0.9126 0.9859 87.16 0.0 1.214 0.3566 0.8299 0.9725 105.31
0.10 1.080 0.3581 0.9051 1.0113 94.40 0.25 1.144 0.3585 0.9008 1.0319 98.33
0.15 1.144 0.3585 0.9008 1.0319 98.33 0.50 1.028 0.3599 0.9561 1.0638 88.41
0.20 1.189 0.3588 0.8981 1.0503 100.74 0.75 0.906 0.3608 0.9955 1.0763 78.12
International Review of Finance r International Review of Finance Ltd. 2011

0.25 1.223 0.3591 0.8967 1.0675 102.24 1.0 0.795 0.3615 1.0236 1.0765 68.71
Variables:
x, earnings level, $ per unit time; I, investment required for expansion ($); s, volatility of earnings stream; a1, fractional bankruptcy costs for
existing assets; a2, fractional bankruptcy costs for expansion option; pn, optimal fractional increase in coupon at expansion; x0, optimal pre-
expansion default trigger; xF, first-best expansion trigger; c, pre-expansion coupon; $, per unit time; r, risk-free interest rate; m, drift rate of earnings
stream; y , expansion scale; t, effective tax rate; K, amount of debt issued at expansion ($); xn, optimal expansion trigger.
Base case parameter values: I510, r56%, m50, s515%, c50.6, t515%, a150.25, a250.5, and y 51.
73
Initial (pre-expansion) debt level or leverage ratio: According to the traditional

tax–bankruptcy cost trade-off theory, the company will try to revert to its target
leverage ratio, which implies a negative relationship between existing debt level
and expansion debt usage. However, the effect of the shareholder–bondholder
agency problem is exactly the opposite, as discussed in Section IIC. From the
numerical results in Table 2, we see that the former dominates: the debt
component of the optimal expansion financing package is a decreasing
function of the initial leverage ratio. Thus, a high-leverage company will use
less debt financing, and a low-leverage company will use more debt financing,
for the expansion. Such a relationship is consistent with mean reversion in
leverage ratios, reported in empirical studies by Hovakimian et al. (2001), Fama
and French (2002), Elsas et al. (2006), and Shyam-Sunder and Myers (1999).
Tserlukevich (2008) also predicts mean-reverting leverage ratios, using a real-
option model.
However, the shareholder–bondholder agency problem weakens the negative
relationship between existing debt and expansion debt, since the agency effect
essentially pushes the firm away from the target leverage ratio. Thus, the agency
problem should reduce the incentive to revert to the target leverage ratio, and
slow down the speed of adjustment in leverage ratios. This is consistent with
empirical evidence: while firms do adjust toward a target leverage ratio as
mentioned above, Fama and French (2002), Kayhan and Titman (2007), and
others find the adjustment (or the rate of mean reversion) to be quite slow.
Moreover, while adjustment costs may explain part of the slowness (Faulkender
et al. 2007), they cannot explain it completely; as DeAngelo and DeAngelo
(2007, p. 1) note, the trade-off theory ‘fails to explain why leverage rebalancing
is difficult to detect and, when detected, why it occurs with a delay that is not
plausibly explained by adjustment costs.’ Thus, the agency problem might help
explain, at least in part, the observed sluggishness in adjustment of leverage
ratios to target levels.
Growth opportunity (y): The debt component of the optimal expansion
financing package is a decreasing function of the magnitude of the growth
opportunity. Thus, companies with large growth opportunities (commonly
proxied in the literature by companies with high market-to-book ratios) should
use less debt and more equity to finance expansions. This implication is
supported by empirical results of Hovakimian et al. (2001 and 2004) and
Gatchev et al. (2006).
This relationship can also be viewed as follows: for a given I, a higher y
represents a more attractive project. Then the implication of this result is that
more attractive or profitable project will be financed by lower debt component
and higher equity component. This is consistent with the empirical finding of
Gaud et al. (2004) that equity financing is favored for more profitable projects.
Investment required for expansion (I): The debt component of the optimal
expansion financing package is an increasing function of the investment
required to implement the expansion (I). A lower I, everything else held
unchanged, makes the new project more attractive or profitable. Thus, the
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empirical implication is that more attractive projects will be financed less by

debt and more by equity, consistent with Gaud et al. (2004).
Other parameters: The optimal expansion debt component is an increasing
function of the earnings volatility s, earnings growth rate m, risk-free interest
rate r and tax rate t, and a decreasing function of the existing assets’ bankruptcy
cost (a1), but it is independent of the growth option’s bankruptcy cost (a2). In
the comparative static results of this section, we note that any factor that makes
the expansion project less attractive (higher I, s, t or r, lower y) results in a
higher optimal debt component. The comparative static properties of the
optimal expansion financing package are summarized in:
i. Result 2
The debt component of the optimal expansion financing package is an increasing

function of the cost of the expansion (I), earnings volatility (s), earnings growth
rate (m), interest rate (r) and tax rate (t); a decreasing function of the initial
leverage ratio, expansion scale (y), and assets-in-place bankruptcy cost (a1); and
independent of growth option bankruptcy cost (a2).
Importance of the debt component in the optimal expansion financing package: As

seen above, the optimal expansion financing package in the base case consists
of mostly debt (over 98%). This is not surprising in a real-option model where
the company has the timing option, which results in expansion in good states
(when earnings are high, hence the firm is relatively under-leveraged); this leads
to a preference for debt financing. However, this preponderance of debt holds
for all initial leverage ratios, as we see in Table 2 (comparative statics with
respect to c). For initial c50.2 (leverage ratio of 30.72%) the optimal expansion
financing package is all debt, and for c51.0 (leverage ratio of 98.63%) the
optimal package still consists of about 88% debt. Thus the preference for debt in
the expansion financing package is independent of the initial financial
structure.
From Table 2, it is clear that the optimal financing package generally consists
of significantly more debt than equity; the exception is, not surprisingly, for low
tax rate and high bankruptcy cost. Thus, our model (which is basically a trade-
off model with agency problems, with no behavioral considerations or
asymmetric information) has a similar prediction as the pecking order
hypothesis regarding expansion financing.14 This corporate preference for debt
14 Note, however, that our model identifies a specific optimal combination of debt and equity,
whereas the pecking order hypothesis implies a general preference for debt financing. In the
pecking order hypothesis, the order of preference is debt, hybrids and equity. Presumably, if the
firm exhausts its ability to issue any more debt, it turns to hybrids and then equity. However,
companies routinely issue a combination of straight debt and equity (bypassing hybrids), see
Hovakimian et al. (2001 and 2004). Moreover, the pecking order hypothesis ignores tax effects,
which have been shown to be important in corporate financing decisions (Graham 2003). For
instance, for a firm with zero or very low effective tax rate, the pecking order hypothesis would
still recommend debt as the optimal choice, which does not seem reasonable.
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financing is consistent with the theoretical prediction of Tserlukevich (2008) as

well as empirical studies of financing patterns, which report that debt
dominates equity in terms of the amount of financing for new investments,
e.g., Shyam-Sunder and Myers (1999), Hovakimian et al. (2001), Chen and Zhao
(2005), and Elsas et al. (2006).
Also, if high flotation costs compel the firm to use only one source of
financing, the above-mentioned dominance of debt implies that debt will be
the more popular choice. This is consistent with corporate financing patterns.15
F. Properties of the optimal expansion trigger xn

Table 2 also shows the comparative static results for the optimal investment
trigger xn. The role of the investment trigger is of interest because of its
implications regarding the timing of investment: a decrease in xn implies earlier
investment, hence a lower xn denotes a positive effect on investment and a
higher xn denotes a negative effect. Thus the optimal trigger is an important
factor in corporate investment. The table also reports the first-best expansion
trigger xF, which is in all cases found to be greater than xn, indicating
overinvestment. Thus the overinvestment incentive dominates the under-
investment incentive.
The optimal investment trigger xn is found to be an increasing function of c
(or the initial leverage ratio). This is not surprising, since the underinvestment
incentive increases with the existing debt level (Myers 1977). Therefore, a
company with a higher debt burden will delay investment, i.e., a higher pre-
expansion leverage ratio has a negative effect on investment. This prediction is
consistent with the empirical results of Aivazian et al. (2005), Lyandres and
Zhdanov (2005), and Lang et al. (1996). The effect of debt financing on
investment can be summarized as follows: pre-expansion debt has a negative effect,
and expansion debt has a positive effect, on the company’s investment (the latter
from Section IF).
Next, xn is a decreasing function of the magnitude of the growth opportunity
y, i.e., growth opportunities have a positive effect on investment. This is not a
surprising result, and is consistent with the empirical findings of Aivazian et al.
(2005) and Lyandres and Zhdanov (2005), who report that investment is
positively related to the market-to-book ratio.
Also, high investment cost (I), high bankruptcy cost (a1), high interest rate
(r), and high volatility (s) all have a negative impact on investment, while high
earnings growth rate (m) and high corporate tax rate (t) have a positive impact
on investment. The surprising effect of tax rate arises from the fact that a higher
tax rate makes debt more attractive and thus increases the debt component,
which has a positive effect on investment because of the overinvestment
15 Hovakimian et al. (2001, p. 4) state, ‘cross-sectionally, we observe that long-term straight debt
issues are the most frequent way of raising capital in our sample.’ Chen and Zhao (2005) and
Shyam-Sunder and Myers (1999) also report that debt is the main source of external finance.
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incentive. The comparative static properties of the optimal expansion trigger xn

(with the optimal financing package) are summarized in:
i. Result 3
The optimal expansion trigger xn is an increasing function of the initial leverage
ratio, cost of the expansion (I), earnings volatility (s), interest rate (r), and
assets-in-place bankruptcy cost (a1), and a decreasing function of the expansion
scale (y), earnings growth rate (m), and tax rate (t).
III. OPTIMAL PRE-EXPANSION CAPITAL STRUCTURE
A. The optimal pre-expansion debt level

Up to this point, it has been assumed that the pre-expansion debt level (c) is
specified. However, if equity holders can choose this initial debt level, how
should they go about determining it, given their knowledge of the expansion
option? Assuming no informational asymmetries, (i.e., the new debt is issued at
a fair price) the optimal course of action would be to maximize the total firm
value (debt plus equity), as in Leland (1994). Thus the optimal ex-ante debt level
is given by
c ðxÞ ¼ arg maxfEðx; cÞ þ Dðx; cÞg ð19Þ

c
In this decision, the equity and debt values, hence the optimal debt level,
will depend on how the expansion option is financed and exercised. Unless
otherwise specified, we will assume that the expansion trigger and expansion
financing package will both be chosen optimally, as in Section IIB.
There being no analytical solution to equation (19), the optimal pre-
expansion debt level has to be identified numerically. As c is increased, both
the tax benefits and expected bankruptcy costs of debt increase; in addition,
there is the investment effect – if c is low the firm will invest early, and if c is
high the firm will invest late. The overall effect of c on total firm value then
has the familiar inverted U-shape, i.e., initially increasing and then
decreasing in c.
Computing the total firm value {E(x,c)1D(x,c)} for different values of c, we
find that, as expected, it is initially increasing and subsequently decreasing in
c. For the base case parameter values and x50.6, the total firm value is
maximized at cn50.362 (found numerically), corresponding to an interest
coverage ratio of 0.6/0.36251.66, and a market leverage ratio (debt over total
assets) of 51.76%, with total current firm value510.2587 (components:
debt55.3104, equity54.9483; and yield on the debt is 6.82%). With this
financial structure, expansion will occur when xn50.8695; the other
expansion details are as follows: pn52.084, mn50.6485, and debt financing
(K)511.1263.
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B. Optimal pre-expansion debt in the presence of constraints

The above pre-expansion capital structure is optimal under the assumption
that the subsequent expansion will be optimal in both its financing and
timing. If there are covenants that constrain the exercise or financing of the
expansion option (such as those discussed in Section IID.), the pre-expansion
leverage decision must be modified accordingly. As an illustration, let us look
at the covenant that prohibits all future debt issues, i.e., p50 or m5(11y),
which implies that the expansion will be all equity financed. Repeating the
above numerical exercise with this constraint, we get the optimal debt level
cn50.397. Thus, the covenant-constrained firm will use more pre-expansion
debt than the unconstrained firm. This is not surprising – because the firm is
not allowed to raise debt in the future, it will issue more debt upfront; also,
because bondholders are now protected from future wealth expropriation,
they will be willing to accept a lower yield because of the lower risk, hence it
is optimal to use more debt. The other outputs are leverage ratio558.13%,
total current firm value510.1191 (components: debt55.8824, equi-
ty54.2367; and yield on debt 6.75%). The expansion details are: xn51.1010,
pn50, mn52, and K50.
We can note the following: (i) there is a significant delay in expanding
because new debt is ruled out (the underinvestment incentive of Myers 1977),
(ii) the leverage ratio is higher, (iii) in spite of the higher leverage ratio, the yield
on the debt is lower because of the protection provided by the covenant, and
(iv) total firm value falls from 10.2587 to 10.1191, hence shareholders suffer a
loss of 1.36% because of the covenant. Note that this (ex-ante) shareholders’ loss
from the covenant is much smaller than the ex-post shareholders’ loss of 9.83%
computed in Section IID.
C. Determinants of pre-expansion capital structure

We have shown above how to identify the optimal initial (pre-expansion)
leverage ratio for a company with an expansion opportunity. In the following
sections, we examine two major determinants of this optimal pre-expansion
leverage ratio. Regarding the determinants of capital structure, Hovakimian et
al. (2004, p. 518) state: ‘The effects associated with profitability and market-to-
book have been found to be especially important.’ We therefore examine the
role of these two variables in the pre-expansion capital structure. The other
determinants (t, a1, m, r, etc.) have already been examined in the literature (e.g.,
Leland 1994), hence we do not focus on them.
In our model, profitability is represented by the earnings level (x), and the
market-to-book ratio (which is an empirical measure of growth opportunities) is
represented by the expansion scale (y). In order to study the effect of x and y on
the optimal pre-expansion leverage ratio, the numerical procedure of Section
IIIA. was repeated with different values of x and y, respectively. The comparative
statics are summarized in Table 3 and discussed below.
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Table 3 Comparative static results for optimal pre-expansion leverage ratio

y c pn x0 xn Leverage K/I (%)
0.5 0.365 2.770 0.2359 1.5916 0.5852 152.64

0.75 0.362 2.334 0.2311 1.1212 0.5566 125.85
1.0 0.362 2.084 0.2264 0.8695 0.5176 111.26
1.25 0.371 1.878 0.2250 0.7137 0.4776 101.86
x c pn x0 xn Leverage K/I (%)
0.4 0.242 3.326 0.1543 0.8618 0.5572 120.22

0.5 0.300 2.598 0.1896 0.8649 0.5353 115.72
0.6 0.362 2.084 0.2264 0.8695 0.5176 111.26
0.7 0.422 1.737 0.2611 0.8754 0.5055 107.38
0.8 0.509 1.389 0.3097 0.8864 0.4983 102.49
For y51.5, we have xnox, i.e., it is optimal to expand immediately.
Variables:
x, earnings level $ per unit time; I, investment required for expansion ($); s, volatility of earnings
stream; a1, fractional bankruptcy costs for existing assets; a2, fractional bankruptcy costs for
expansion option; x0, optimal pre-expansion default trigger; pn, optimal fractional increase in
coupon at expansion; c, pre-expansion coupon, $ per unit time; r, risk-free interest rate; m, drift
rate of earnings stream; y, expansion scale; t, effective tax rate; xn, optimal expansion trigger; K,
amount of debt issued at expansion ($).
Base case parameter values: I510, r56%, m50, s515%, t515%, a150.25, a250.5, y51, and x50.6.
D. Effect of growth opportunities (y)

Figure 3 shows total firm value as a function of the leverage ratio, for y50.5, 1,
and 1.25. It is clear from the figure that the optimal leverage ratio falls as the
expansion scale y is increased. This is confirmed in Table 3. However, the
optimal coupon level (c) initially falls and subsequently rises when y is
increased, as Table 3 also shows. Thus, (i) the effect of growth opportunities on
the optimal debt level or coupon cn is ambiguous, but (ii) growth opportunities
have an unambiguous negative effect on the optimal leverage ratio.
Barclay et al.’s (2006) model predicts that growth opportunities will have a
negative effect on both optimal debt level (c) and optimal leverage ratio, while
Sundaresan and Wang’s (2006) model predicts a negative relationship between
leverage ratio and growth opportunities.
In empirical work, as discussed by Barclay et al. (2006), the debt level is
generally represented by the book-value leverage ratio, while the leverage ratio
derived above is represented by the market-value leverage ratio. Thus the
empirical implication of our model is: The effect of growth opportunities
(usually measured by market-to-book ratio or Tobin’s Q) on book-value leverage
ratio cannot be unambiguously specified, but it has an unambiguous negative
effect on market-value leverage ratio.
Regarding book-value leverage, Barclay et al. (2006) report a negative
relationship between growth opportunities and book-value leverage ratio,
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12
11 = 1.25
Total firm value
10 =1
9 = 0.5
7
20 30 40 50 60 70 80 90 100
Leverage ratio (%)
Figure 3 Total Pre-Expansion Firm Value (Equity Plus Debt) as a Function of the
Leverage Ratio, for Three Different Values of the Expansion Scale, y.
The Optimal Leverage Ratio is Shown by the Corresponding Vertical Line; it is 58.52,
51.76 and 47.76% for y50.5, 1, and 1.25, Respectively; it is therefore a Decreasing
Function of y. The Base Case Parameter Values are I510, r56%, m50, s515%, c50.6,
t515%, a150.25, and a250.5.
while Fama and French (2002) and Chen and Zhao (2006) report a positive
relationship; hence the empirical evidence is mixed. However, the evidence on
market-value leverage is unambiguous: growth opportunities have a negative
effect on market-value leverage ratio, as reported by Titman and Wessels (1988),
Rajan and Zingales (1995), Hovakimian et al. (2004), Barclay et al. (2006), and
many others.
The negative leverage–growth relationship arises, in our model, from the
expansion financing decision. If a firm has more leverage now it will be optimal
to use less debt for the expansion (as shown in Section IIE), which will have a
negative effect on investment because of the underinvestment incentive. This
will harm equity holders because bondholders will incorporate this effect in the
valuation of the bonds and will pay a correspondingly lower price. Therefore, a
company with larger growth opportunities (higher y) will use less leverage now,
so that it has the flexibility to use more debt for future expansion. Financial
slack, or maintaining unused debt capacity, is particularly valuable when
growth opportunities are large. The effect of growth options on the optimal
current financial structure is summarized in:
i. Result 4
The optimal initial or pre-expansion leverage ratio (in market value terms) is a
decreasing function of the magnitude of the growth opportunity (y).
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E. Effect of earnings level (x)
The second important determinant of corporate leverage is profitability or

earnings x (Hovakimian et al. 2004). While the trade-off theory predicts a
positive relationship between leverage ratio and profitability, the actual effect is
exactly the opposite, as widely documented (Fama and French 2002; Chen and
Zhao 2005; Faulkender et al. 2007, etc.). Faulkender et al. (2007, p. 4) state:
‘Profitability has consistently worked in the opposite direction of what would
be predicted by a static trade-off theory . . .’. Two suggestions that have been
offered to reconcile the evidence with the trade-off theory are the ‘costly
adjustment’ and ‘dynamic tax’ explanations (Chen and Zhao 2005). However,
Chen and Zhao (2005) demonstrate empirically that the negative relationship
between profitability and leverage largely survives after controlling for both
these considerations, hence these factors do not fully explain the negative
relationship.
From Table 3, we see that while the optimal debt level cn increases with x
(which is not surprising), the optimal leverage ratio is a decreasing function of x.
Therefore, our model predicts a negative relation between earnings and
leverage, contrary to the traditional trade-off theory but consistent with the
empirical evidence.16 Moreover, this negative relationship is not a temporary
off-optimal situation resulting from market frictions; rather, this is an optimal
relationship. Because our model is basically a trade-off model with expansion,
this result might help reconcile the trade-off theory with the observed leverage–
profitability relationship. The relationship is stated formally in:
i. Result 5
The optimal pre-expansion leverage ratio is a decreasing function of profit-

ability or earnings level (x).
The negative relationship between earnings and optimal leverage ratio can
be explained by the fact that the total firm value is the sum of two
components: value of current operations and value of the expansion option.
When x is smaller, the second component is less important because x is farther
from the expansion trigger xn. In Section IIIB, we saw that when growth
opportunities become less important, the optimal leverage ratio is higher.
Therefore, the optimal leverage ratio is higher when x is smaller. For higher x,
the expansion trigger is closer, hence the growth opportunity constitutes a
larger fraction of firm value. Thus, the growth opportunity become more
important when x is higher, resulting in a smaller optimal leverage ratio. This
results in a negative relationship between the earnings level and the optimal
leverage ratio.
16 Note that Tserlukevich’s (2008) model also makes this prediction, without relying on agency
problems.
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IV. CONCLUSION
In this paper, we address the following question: what is the optimal

combination of debt and equity to finance an expansion project, for a given
existing financial structure? Along with the optimal financing package, we
simultaneously compute the optimal expansion trigger. Expansion financing is
different from the standard capital structure problem because the initial capital
structure affects the optimal expansion financing package, which in turn affects
the optimal expansion trigger. It is shown that the ability to issue new debt to
finance the expansion project is valuable, and shareholders could suffer
significant reduction in value if they did not have the flexibility to do so.
The optimal expansion financing package is found to generally contain more
debt than equity. The debt component will be higher if the initial or pre-
expansion leverage ratio is low and if the cost of the expansion is high, and will
be lower if the expansion scale is large. Also, the optimal expansion trigger is an
increasing function of the initial leverage ratio but a decreasing function of the
debt used for the expansion; thus, existing debt has a negative effect while
expansion debt has a positive effect, on investment.
In addition to expansion financing, we also compute the optimal initial
leverage ratio, which is found to be a decreasing function of growth
opportunities and earnings level. These relationships are generally consistent
with the available empirical evidence or corporate financing decisions. Our
results can help reconcile the trade-off theory with some seemingly contra-
dictory empirical regularities, e.g., the preponderance of debt in new financing,
and the negative relationship between earnings and leverage.
Sudipto Sarkar
McMaster University
Hamilton
ON, Canada L8S 4M4
sarkars@mcmaster.ca
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APPENDIX A. VALUING POST-EXPANSION SECURITIES
After expansion, the earnings flow is (11y)xt, where xt follows the stochastic
process (1). As in Goldstein et al. (2001), the value of this earnings stream (or
the value of the firm’s assets) is given by V2(x)5(1–t)(11y)x/(r–m). Both equity
and debt will be (perpetual) contingent claims on the state variable x. The value
of such a contingent claim, say Z(x), must satisfy the standard ordinary
differential equation (ODE)
0:5s2 x2 Z00 ðxÞ þ mxZ0 ðxÞ rZðxÞ þ z ¼ 0 ðA1Þ
where z is the payout flow to the contingent-claim holder. For post-expansion
debt, we have z5(11p)c and for post-expansion equity z5(1–t)[(11y)x – (11p)c].
Debt: Let F(x) be the value of the post-expansion debt. Then, solving equation
(A1) with the appropriate z, we get
FðxÞ ¼ ð1 þ pÞc=r þ Axg2 þ Bxg1 ðA2Þ
The constants A and B can be computed from the boundary conditions.
Boundary condition 1: At the upper boundary (when x reaches very high values,
x ! 1), the debt becomes effectively risk-free, so its value must approach (11p)c/r,
which implies B50 in equation (A2). Thus, we write debt value as
FðxÞ ¼ ð1 þ pÞc=r þ Axg2 ðA3Þ
Boundary condition 2: At default, (x5xD), bondholders acquire the assets of the
company [worth V2(xD)], and incur fractional bankruptcy costs of a1. This gives
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the boundary condition

FðxD Þ ¼ ð1 þ pÞc=r þ AðxD Þg2 ¼ ð1 a1 Þð1 tÞð1 þ yÞxD =ðr mÞ ðA4Þ
g2
giving A ¼ ½ð1 a1 Þð1 tÞð1 þ yÞxD =ðr mÞ ð1 þ pÞc=rðxD Þ . Substituting for
A, we get
FðxÞ ¼ ð1 þ pÞc=r þ ½ð1 a1 Þð1 tÞð1 þ yÞxD =ðr mÞ ð1 þ pÞc=rðx=xD Þg2 ðA5Þ
Equity: Similarly, if G(x) is the equity value after expansion, we have:
GðxÞ ¼ ð1 tÞ½ð1 þ yÞx=ðr mÞ ð1 þ pÞc=r þ Cxg2 þ Dxg1 ðA6Þ
where the constants C and D are computed from the boundary conditions.
Boundary condition 1: Again, if x reaches very high levels (x ! 1), default
becomes very unlikely, hence the equity value will approach (1t)[(11y)x/
(rm)(11p)c/r], which implies D50 in equation (A6). Thus we can write the
equity value as:
GðxÞ ¼ ð1 tÞð1 þ yÞx=ðr mÞ ð1 tÞð1 þ pÞc=r þ Cxg2 ðA7Þ
Boundary condition 2: At default, (x5xD), the payoff to shareholders is zero,
hence the boundary condition is:
GðxD Þ ¼ ð1 tÞ½ð1 þ yÞxD =ðr mÞ ð1 þ pÞc=r þ CðxD Þg2 ¼ 0 ðA8Þ
g2
giving C ¼ ð1 tÞ½ð1 þ pÞc=r ð1 þ yÞxD =ðr mÞðxD Þ , and
GðxÞ ¼ð1 tÞfð1 þ yÞx=ðr mÞ ð1 þ pÞc=r
ðA9Þ
þ ½ð1 þ pÞc=r ð1 þ yÞxD =ðr mÞðx=xD Þg2 g
Finally, for xD to be the optimal trigger, the smooth-pasting condition
requires
G0 ðxD Þ ¼ 0 ðA10Þ
cð1m=rÞ
Equations (A9) and (A10) give xD ¼ mð11=g2 Þ,
where m5(11y)/(11p) is the
interest coverage multiple. Substituting for xD into F(x) and G(x), we get
equations (2) and (3) of the paper.
APPENDIX B. VALUING THE SECURITIES BEFORE EXPANSION
Before expansion, the earnings level is x, hence the value of the assets-in-place
is V1(x)5(1t)x/(rm). Both debt value and equity value must satisfy the ODE
(A1) with z5c for debt and z5(1–t)(x – c) for equity. The solutions give equations
(8) and (9) of the paper.
APPENDIX C. VALUING THE EXPANSION OPTION AT DEFAULT
At default, equity holders exit the picture, and all the assets (including the
expansion option) revert to the bondholders. Thus, at default, the firm becomes
unlevered. The rest of this section refers to the post-default unlevered firm, and
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the option to expand can be valued exactly as in the traditional (unlevered)

case, e.g., McDonald and Siegel (1986).
From Appendices A and B, the value of the cash flows before expansion is
V1(x)5(1–t)x/(r–m), and the value of the cash flows after expansion is
V2(x)5(11y)(1t)x/(rm). The expansion option allows the shareholders (i.e.,
the former bondholders) to replace the pre-expansion assets with the post-
expansion assets at a cost I. Thus, if xe is the expansion trigger, the payoff at
exercise will be
V 2 ðxe Þ V 1 ðxe Þ I ¼ yð1 tÞxe =ðr mÞ I ðA11Þ
Let the value of the option to expand be H(x). Then, H(x) must also satisfy the
ODE (A1) with z50, which gives
HðxÞ ¼ Axg1 þ Bxg2 ðA12Þ
However, the option value must approach zero as x approaches zero, which
implies B50 in equation (A12). Thus we can write HðxÞ5Axg1.
The value-matching condition at option exercise is
yð1 tÞxe
Aðxe Þg1 ¼ I ðA13Þ
rm
For the expansion option exercise trigger to be optimal, it must satisfy the
smooth-pasting condition:
Ag1 ðxe Þg1 1 ¼ yð1 tÞ=ðr mÞ ðA14Þ
Solving equations (A13) and (A14), we get
Iðr mÞ
xe ¼ ðA15Þ
yð1 tÞð1 1=g1 Þ
A ¼ ½yð1 tÞxe =ðr mÞ Iðxe Þg1 ðA16Þ
Then the post-default option value is given by Ax ¼ ½yð1 tÞxe = g1
ðr mÞ Iðx=xe Þg1 . Substituting for xe, we get

I ð1 tÞyð1 1=g1 Þx g1
Axg1 ¼ ðA17Þ
ðg1 1Þ Iðr mÞ
Thus, the value of the expansion option at default (x5x0) is given by

I ð1 tÞyð1 1=g1 Þx0 g1
Aðx0 Þg1 ¼
ðg1 1Þ Iðr mÞ
This is the formula used in the paper (Section IE) when valuing debt.
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Optimal Expansion Financing and Prior Financial Structure

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International Review of Finance, 11:1, 2011: pp.

Optimal Expansion Financing and

We derive the optimal financing package, as well as the optimal investment

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Sundaresan and Wang (2006) study investment, financing and default

I. THE OPTIMAL EXPANSION DECISION FOR A SPECIFIED

A. The existing operations

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Table 1 Notation used in the model

B. The expansion option

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In this setting, the optimal investment policy is to expand as soon as x rises

C. Valuing the post-expansion securities

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D. Financing the expansion

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E. Valuing the pre-expansion securities

Debt : DðxÞ ¼ c=r þ D1 xg2 þ D2 xg1 ð8Þ

Thus, the first boundary condition is

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G. Comparison of optimal and first-best expansion triggers

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We first note that, in a frictionless world, xF is independent of expansion

Therefore, when to invest, and whether there will be underinvestment or

II. THE OPTIMAL EXPANSION FINANCING PACKAGE

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A. Expansion financing and equity value

There is no analytical solution to equation (16), hence mn has to be identified

B. The base case

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increasing and subsequently decreasing in m. In all cases, irrespective of the

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C. Optimal financing for a stand-alone expansion project

and the corresponding amount of debt is

13 The complete derivation is available from the author on request.

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D. Optimal expansion financing in the presence of constraints

E. Properties of the optimal expansion financing package

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I pn x0 xn xF K/I (%) z pn x0 xn xF K/I (%)

International Review of Finance r International Review of Finance Ltd. 2011

Initial (pre-expansion) debt level or leverage ratio: According to the traditional

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empirical implication is that more attractive projects will be financed less by

The debt component of the optimal expansion financing package is an increasing

Importance of the debt component in the optimal expansion financing package: As

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financing is consistent with the theoretical prediction of Tserlukevich (2008) as

F. Properties of the optimal expansion trigger xn

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incentive. The comparative static properties of the optimal expansion trigger xn

III. OPTIMAL PRE-EXPANSION CAPITAL STRUCTURE

A. The optimal pre-expansion debt level

c ðxÞ ¼ arg maxfEðx; cÞ þ Dðx; cÞg ð19Þ

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B. Optimal pre-expansion debt in the presence of constraints

C. Determinants of pre-expansion capital structure

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ðr mÞ Iðx=xe Þg1 . Substituting for xe, we get