Proceedings of the 8th International Conference On Humanities, Psychology and Social Science
Capital Structure, Financial Flexibility and Real Options
The field of research on capital structure has existed for six decades until today. It started with the initiative paper from Modigliani / Miller in 1958. Since then, there has been a lively debate on the issue of optimal capital structure, which has taken place in both theory and practice of corporate finance. The optimal capital structure is defined as the one that increases or even maximizes a company’s – relative – profitability and indirectly its value.
Very roughly, the capital structure debate divides into two parts. The one of them mainly concentrates on capital costs, risks and other parameters and their potential effect on the value of a company. The other part of the debate examines the potential interaction between the capital structure and the decisions regarding real investments – and then the following effects on the earnings and value of a company.
This paper intends to deal primarily with the second part of the capital structure debate. It follows the idea of investigating financial flexibility as a potential cause of higher company profitability and value and intends to investigate this view using the real options approach. The real option theory is an independent field of research. It follows the theoretical approach of understanding investment opportunities – under special circumstances – as real options that are – at least partly – comparable to financial options. This field of research started with an initiative paper of Myers in 1977.
The topic of financial flexibility combines the theory of capital structure with the theory of real options. Following this promising connection, this paper first discusses the consideration of financial flexibility as a real option theoretically and then illustrates it by employing a rather simple empirical approach. A relatively new and alternative understanding of the definition of the capital structure is also applied. Resulting, the analysis of this paper shows that companies that remain financially flexible – by keeping their debt capacity open – tend to show relatively better performance figures.
Keywords: Capital structure, financial flexibility, real options, debt capacity, strategic finance.