A Dynamic Model of Optimal Investment and Financial Policies with Costs of Adjustment and Leverage

In this study, a dynamic-optimizing framework is developed in which the interaction between the firm’s real and financial decisions may be examined. The derivation of the objective function is based explicitly on the maximization of shareholder wealth subject to the firm’s cashflow and capital accumulation constraints. By incorporating the financial aspects of investment into a model of optimal capital accumulation, it is shown that changes in "q" may affect the firm's capital structure as well as its investment policies. Although an increase in q generally implies an increase in investment, its impact upon capital structure is shown to depend upon how the marginal costs of leverage vary with investment. It is also demonstrated that marginal q equals a particular tax-adjusted average q which renders the relation between q and capital structure a testable hypothesis.