Expansion Financing and Capital Structure

Abstract

We analyze the financing of an expansion project, as well as the pre-expansion capital structure decision. Using too much equity (debt) in the expansion financing results in under (over)-investment relative to the first-best (total firm value maximizing) policy. We identify the expansion financing packages that ensure first-best as well as second-best (optimal, or equity value maximizing) policies, and show that they are in general quite different. The optimal expansion financing package generally implies a significantly larger debt component than the first-best. With optimal expansion financing, the model's implications are consistent with empirical regularities such as (i) existing debt has a negative effect, while the debt component of expansion financing has a positive effect, on investment; (ii) the debt component of expansion financing is generally a decreasing function of the existing debt level, except for highly-levered firms; and (iii) the debt component of expansion financing is decreasing in growth opportunities.

The ex-ante (pre-expansion) leverage ratio is also identified for both cases - first-best and second-best expansion financing. In the latter case, the model's implications are again consistent with empirical regularities: (i) growth opportunities have a negative effect on both book and market optimal leverage ratios; and (ii) optimal leverage ratio is negatively related to earnings or profitability. Overall, the available empirical evidence suggests that expansion decisions are usually second-best, i.e., made to maximize equity value rather than total firm value.

Keywords: Real option, Expansion, Agency problems, Under-investment, Over-investment

JEL Classification: D81, D92, G31, G32