Title: On the Neutrality of Debt in Investment Intensity
Reference Number: 1197
Publication Date: September 2009
JEL Classifcation: G31, G32, G33

Kit Pong Wong
The University of Hong Kong

This paper examines the interaction between investment and financing decisions of a firm using a real options approach. The firm is endowed with a perpetual option to invest in a project at any time by incurring an irreversible investment cost at that instant. The amount of the irreversible investment cost is directly related to the intensity of investment that is endogenously chosen by the firm. At the investment instant, the firm can finance the project by issuing debt and equity, albeit subject to an exogenously given credit constraint that prohibits the firm's debt-to-asset ratio from exceeding a prespecified threshold. The optimal capital structure of the firm is determined by the trade-off between interest tax-shield benefits and bankruptcy costs of debt. Irrespective of whether the exogenously given credit constraint is binding or not, we show that leverage has no impact on the firm's optimal investment intensity, thereby rendering the neutrality of debt in investment intensity. Similar to earlier work, we show that debt is not neutral to investment timing in general, and the levered firm invests earlier than the unlevered firm in particular.

Published in Annals of Finance 6, pp. 335-356, July 2010.

Key words: Capital structure, Investment intensity, Investment timing, Real options

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Last modified: 10/07/2010