Executive Summary:
We examine interactions between flexible financing and investment decisions in a model with stockholder-bondholder conflicts over investment policy. We find that financial flexibility encourages the choice of short-term debt thereby dramatically reducing the agency costs of under- and overinvestment. However, the reduction in agency costs may not encourage the firm to increase leverage, since the firm’s initial debt level choice depends on the type of growth options in its investment opportunity set. When future growth options increase risk, the firm chooses a larger level of debt when it has financial flexibility than when it does not. Only when future growth options involve an expansion of assets-in-place does a firm with financial flexibility choose a smaller level of debt.
JEL classification: G13; G31; G32; G33
Keywords: Capital structure; Stockholder-bondholder conflicts; Real options
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