Optimal Capital Structure and Investment with Real Options and Endogenous Debt Costs

We examine the joint optimization of financial leverage and irreversible capacity investment in a real options framework with risky debt and endogenous interest costs. Higher capacity, ceteris paribus, increases operating leverage and default probability, but lowers ex post adjustment costs and generates larger tax shields. A key insight is that financial leverage and capacity are substitutes in the debt market equilibrium. We develop novel predictions about the effects of capital adjustment costs, operating costs, and uncertainty on optimal financial leverage and capacity that may potentially help explain ambiguous empirical results in the literature regarding the determinants of capital structure and investment.