Abstract
In this paper, we develop a structural model that captures the interaction between the cash balance and investment opportunities for a firm that already has some debt outstanding. We consider a firm whose assets produce a stochastic cash flow stream. The firm has an opportunity to expand its operations, which we refer to as an "option the expand." The exercise cost of the option can be financed either by cash or costly equity issuance. In the absence of cash, we derive implicit solutions for equity and debt prices when the option is exercised optimally, under both firm value and equity value maximization objectives. We characterize the optimal exercise boundary of the option, and its impact on the optimal capital structure and the debt capacity of the firm. Next, we develop a binomial method to investigate the interaction between cash accumulation and the option to expand. In this framework, the firm optimally balances the payout of dividends with the buildup of a cash balance to finance the expansion in the "good states" (i.e., high asset value states), and to provide liquidity in the "bad states'' (i.e., low asset value states). We provide a complete characterization of the firm's strategy in terms of its investment and dividend policy. We find that while the ability to maintain a cash balance does not add significant value to the firm in absence of the option to expand, it can be extremely valuable when the option is present. Finally, we demonstrate how our method can be extended to firms with options to expand in multiple stages.