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On the Relation of Debt Capacity and Investment Opportunities Using Option Game Theory Approach

Using option game method, the paper present a model that capture the relation between firms' debt capacity and their investment opportunity engaged in the interest rate, tax rate, instantaneous interest of debt and market uncertainty. After solving in closed form for the optimal debt capacity, we show that the relation between debt capacity and growth option is a non-linear "U" shape relation. The "U" shape relation means that when the rate of return on investment is lower, the optimal debt capacity is decreasing with the rate of return on investment; while the rate of return on investment attain higher level, the optimal debt capacity is increasing with the rate of return on investment. Through this model, the new theoretical interpretations for the empirical results in literature are given in this paper.