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Corporate borrowing and growth option value: The limited liability effect

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  • Jyh-Bang Jou

Abstract

A firm issues bonds before undertaking a risky continuous investment project that is costly to later either expand or contract. The firm’s existing debt load causes it to install a smaller capacity because equity has limited liability. This lowers debt value, but such a cost should be borne by equityholders because debtholders will rationally anticipate equityholders’ future behavior. The firm’s choice of debt levels balances this agency cost against the tax shield benefit. As the firm incurs higher costs to later expand capacity, its growth option value becomes lower. The simulation results of this article are in line with Myers’ conjecture (1977), which states that a firm’s debt capacity is inversely related to its growth option value. Copyright Springer 2001

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  • Jyh-Bang Jou, 2001. "Corporate borrowing and growth option value: The limited liability effect," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 25(1), pages 80-99, March.
    • Handle: RePEc:spr:jecfin:v:25:y:2001:i:1:p:80-99
    DOI: 10.1007/BF02759688
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    References listed on IDEAS

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    1. Bradley, Michael & Jarrell, Gregg A & Kim, E Han, 1984. "On the Existence of an Optimal Capital Structure: Theory and Evidence," Journal of Finance, American Finance Association, vol. 39(3), pages 857-878, July.
    2. Jou, Jyh-Bang, 2001. "Entry, financing, and bankruptcy decisions: The limited liability effect," The Quarterly Review of Economics and Finance, Elsevier, vol. 41(1), pages 69-88.
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    4. Haugen, Robert A & Senbet, Lemma W, 1978. "The Insignificance of Bankruptcy Costs to the Theory of Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 33(2), pages 383-393, May.
    5. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
    6. Gaver, Jennifer J. & Gaver, Kenneth M., 1993. "Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies," Journal of Accounting and Economics, Elsevier, vol. 16(1-3), pages 125-160, April.
    7. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    8. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-347, May.
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    Cited by:

    1. Sudipto Sarkar, 2020. "The relationship between operating leverage and financial leverage," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 60(S1), pages 805-826, April.

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