How investment opportunities impact optimal capital structure

This article addresses the question of how competition for investments among firms in a certain industry impacts their capital structure. We develop a new modelling framework, which simulates financial variables of a set of firms in a given sector. We use it to analyse how firms are competing for new investments. The leverage of the firm impacts its flexibility to react upon investment opportunities, and we show how it can be optimised to maximise the firm’s growth. As an illustration, we then apply the model on a set of European airlines and global pharmaceutical companies. The novelty that this paper introduces is the explicit modelling of the interaction among several companies. Invariably, the literature on optimal capital structure focuses on a single company optimising its capital structure in a world where the actions of its competitors are exogenous. Corporate Finance theory states that the optimisation of investment opportunities is one of three drivers of optimal leverage (together with reduction of the distress costs or tax expenditures). Our results suggest that the optimal capital structure should incorporate the competitive position of the firm as well as the availability of investment opportunities. Our framework allows corporate decision makers (CEOs and CFOs) to incorporate these aspects in their decision making. This article addresses the question of how competition for investments among companies in a certain industry affects their capital structure. The authors develop a new modelling framework that simulates financial variables of a set of firms in a given sector, and uses the framework to analyze how such firms compete for new investments. The leverage of companies affects their flexibility to react to and take advantage of investment opportunities, and the authors show how such flexibility can be optimized to maximize the firm’s growth. As an illustration, they apply the model to a set of European airlines and global pharmaceutical companies. The novelty introduced by this paper is the explicit modelling of the interaction between several companies. The literature on optimal capital structure focuses on individual companies optimizing their capital structure in a world in which the actions of their competitors are exogenous. The authors’ results show how to incorporate the competitive position of the firm as well as the availability of investment opportunities into the capital structure decison.