Real Options and Optimal Capital Structure

Starting from the seminal works by Jensen and Meckling (1976) and Myers (1977) a central concern in corporate finance has been to explain how the agency conflict between bondholders and equityholders affects the investment strategies and the choice of capitalstructure among firms.
It’s common evidence that firms tend to choose large amounts of equity in their capital structure and to set debt levels well below what would maximize the tax benefit of debt.
A recent works by Graham (2000), analyzing a set of U.S. firms in the period 1980-1994, confirms the evidence that “money is left on the table”, i.e. there exist significant unexploited tax savings that firms would achieve if they used less conservative debt policies.
To evaluate the debt policy of a certain firm the author relies on the “kink” of the firm defined as the ratio of the amount of interest required to maximize the tax rate function (the level of interests deduction for each marginal tax rate) to the actual interest expense.
If kink is greater than one, a firm could increase interest expense and expect full benefit on these incremental deductions; such a firm uses debt conservatively.
It turns out that 44 percent of the sample firms have kinks of at least two (they could double interest deductions and still expect to realize full tax benefit from their tax deductions). In particular growth firms that produce unique products are found to use debt conservatively as
well as (surprisingly) large, profitable and liquid firms; even if the trend indicates that this sparing use of debt is slowly scaling down, it is far from disappearing.
All these evidences seem to suggest that debt is someway “costly” for firms and one commonly discussed “cost” of debt arises from the differing objectives of stockholders and debtholders. Stockholders (directly or by the intermediation of the management) are likely to
make investments that maximize their own wealth rather than the total firm value. Since the expected cost of such opportunistic behaviour on the part of stockholders is incorporated into the price of debt when it is issued, the ex-ante solution for stockholders is the use less debt in
the firm’s capital structure.
Starting from Brennan and Schwartz (1984) and following with Mello and Parson (1992), Mauer and Triantis (1994) Leland (1998) et al. contingent claims models, in which investment opportunities are evaluated with a real options approach, have showed to be particularly suited to analyse the problem.
The common reason for using a real option approach here is the uncertainty about the firm’s investment decisions and the related choice of firm’s financing; in this environment, the flexibility to decide what to do after some of the uncertainty is resolved can be well evaluated
by option pricing and optimal stochastic control techniques.
The main goal of this memoire is to present and compare in a homogeneous way some of the most recent contributions on this subject and try to point out some general findings . The
remainder of the memoire is structured as follows. Section 2 describes in a unique framework two theoretical real options models focusing respectively on overinvestment and underinvestment in firm’s policy. Section 3 shows a Montecarlo simulation of investment
distortions in order to evaluate the consistency of the theoretical results of section 2.
Section 4 presents a dynamic extension of contingent claim models to find more accurate estimation of
agency costs and their effect on the optimal capital structure.
Section 5 tries to figure out some possible solutions to the agency problem under the form of bond covenants.
Section 6 summarizes the main conclusions.