Abstract

We develop a general theory of the firm that models investment and financing decisions simultaneously. Equity holders maximise shareholder value over an infinite time horizon through selecting optimal time paths of capital stock. Growth in capital stock is subject to investment constraints determined by the availability of internal and external finance. In order to reach the steady state faster and maximise value, equity holders can select debt and equity issues. The firm’s investment decision and exogenous price shocks influence cash flows. Hence, the firm exhibits default risk due to exogenous shocks and investment decisions.

Debt holders select the debt ceiling, which defines the firm’s debt capacity, to control their exposure to default risk. Cost of debt is determined on the market for external finance and reflects default risk.

The model shows that capital structure affects firm value if the firm has not reached its steady state. In the absence of information asymmetry, the model establishes a pecking order of internal and external finance. Once the firm approaches its steady state, the model converges to the classic Irrelevance Theory. Hence, the model is a general theory of the special case described by Modigliani and Miller (1958).