Leverage Dynamics and Financial Flexibility

We develop a q theory of investment with endogenous leverage, payout, hedging, and risk-taking dynamics. The key frictions are costly equity issuance and incomplete markets. We show that the marginal source of external financing on an on-going basis is debt. The firm lowers its debt when making a profit, increases its debt in response to losses and induced higher interest payments, and even taps external equity markets at a cost before exhausting its endogenous debt capacity. The firm seeks to preserve its financial flexibility by prudently managing its leverage and investment. Paradoxically, it is the high cost of equity issuance that causes the firm to keep leverage low, in contrast to the predictions of static Modigliani-Miller tradeoff and Myers-Majluf pecking-order theories. Our model generates leverage and investment dynamics that are consistent with the empirical evidence