In the Miller and Modigliani (1958) frictionless world, financing decisions are independent of capital investments. In the world with financial distress and costly default, investment and capital structure decisions are made jointly and, therefore, fluctuations in real investments and frictions associated with investments can influence financing choices.
The objective of this paper is to study how investment frictions affect capital structure dynamics. I propose that investment frictions such as time-to-build and lumpiness of investments are important determinants of capital structure fluctuations. Specifically, I provide a theoretical framework for analyzing the role of these frictions and examine whether they can cause time-series and cross-sectional heterogeneity in leverage dynamics.
The role of investment frictions is a new question in the capital structure literature, but it has been well-recognized in the literature of real investments. Since Hayachi (1982), the real investments literature has moved away from conventional frictionless models towards models with frictions commonly including either time-to-build (or investments lags) or lumpiness of investments. Time-to build refers to a time lag required to complete new capital stock. Only after this time lag elapses can the new capital become a part of the productive capital that can generate cash.
The lumpiness of investments does not allow small incremental adjustments in the stock of capital because investments are indivisible. Real world examples of investment frictions may include an oil company building a new oil rig, or an aircraft manufacturer developing a new airplane. In both examples, these new investment expenditures are a substantial fraction of the firms’ overall values, and are subject to a time lag between when investment expenditures are made and when these investments begin to generate cash. Kidland and Prescott (1982) show that the assumption of multiperiod construction is crucial in explaining aggregate economic fluctuations. Caballero and Engel (1999) report that models with lumpy investments perform better than standard linear models in predicting investments of US manufacturing firms. If theories with investment frictions offer a better explanation of real investment behavior, they may also help explain capital structure choices.
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