Optimal Expansion Financing and Prior Financial Structure*

ABSTRACT This paper identifies jointly the optimal investment trigger and the optimal financing package for a corporate expansion project, using a real‐option ‘trade‐off’ model with agency problems. It also identifies the optimal initial capital structure of the firm (before the expansion). We show that it is generally optimal to use more debt than equity to finance the expansion. The other results are as follows: (i) existing debt has a negative effect, while the debt component of expansion financing has a positive effect, on investment; (ii) the debt component of the optimal expansion financing package is a decreasing function of the pre‐expansion leverage ratio (consistent with mean reverting leverage ratios), and is also decreasing in the magnitude of the expansion opportunity; and (iii) the optimal pre‐expansion leverage ratio is a decreasing function of both the firm's profitability and the magnitude of the growth opportunity. These relationships are generally consistent with empirical evidence, and help reconcile the trade‐off theory of capital structure with apparently contradictory empirical evidence.