External growth opportunities and a firm's financing policy

Abstract

This study analyzes how external growth opportunities such as general demand growth impact a firm's financing policy. The model developed in this paper implies that a firm's optimal leverage ratio decreases with growth opportunities if the firm's manager is not highly risk-averse, but increases otherwise. The relation is driven by the respective changes in equity value. Our empirical tests show that equity value is greater and that financial leverage is lower for high-growth firms. This suggests that firms' managers are not highly risk-averse, on average. This paper provides an alternative explanation for the negative relation between leverage and growth opportunities.