Operating flexibility and optimal capital structure

Abstract The effect of operating flexibility on leverage ratio is not clear, with papers pointing to both positive and negative relationships. Using production switching cost as a measure of operating flexibility, we show that it has two opposing effects: it increases firm value (positive) and increases cost of debt (negative), thus the overall effect is ambiguous. In general, however, the overall effect is negative and small in magnitude. It is stronger when profit margin, growth rate, tax rate, and bankruptcy cost are small, and when volatility is large. Our results help reconcile conflicting predictions in the theoretical literature with empirical findings.