A Dynamic Model of Optimal Capital Structure

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Abstract
This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. The model extends the dynamic capital structure literature by endogenizing the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the capital structure choice affects both target debt ratios and the extent to which actual debt ratios deviate from their targets. In particular, we examine how financial distress and the firm's objectives, i.e., whether it makes choices to maximize total firm value versus equity value, influence the extent to which firms make financing choices that move them towards their target debt ratios.