A Dynamic Model of Optimal Capital Structure

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 existing 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 debt choices. The model simultaneously generates quantitative implications on how firm characteristics such as the depreciation rate of the firm's assets, expected future growth opportunities, financial distress costs, taxes and transaction costs affect choice of debt ratios