Determinants of corporate borrowing

Abstract

Abstract Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.