MIT Prof. and Principal Emeritus Stewart C. Myers and Brattle Principal James Read expose the leverage implicit in real options, and explore the implications for financial theory and practice, in the current issue of the Journal of Applied Corporate Finance.

Real options are investment opportunities that will be exploited in the future if they become sufficiently valuable. The capital expenditure that real-option exercise requires is implicit leverage; it acts like debt because it increases financial risk and because not undertaking investments can be costly.

Real-option leverage does not appear on corporate balance sheets, so observed capital structures of firms that hold real options may provide a distorted view of the debt capacity of the underlying assets.  This implies that estimates of the cost of capital based on observed capital structures of such firms will be biased. And it suggests that capital-structure theories will be difficult to test when real options and hidden leverage are important.

The full article, “Real Options and Hidden Leverage,” can be found below.

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