Building up financial flexibility

We ask how firms should build up financial flexibility by optimally preserving "debt capacity" or "equity capacity" through initially choosing high or low target leverage. This depends on whether additional financing is raised at competitive terms or whether there is a lock-in with initial investors, as then there will be a problem of either overinvestment or underinvestment. Firms’ initial (or target) capital structure matters as it aspects the "outside option" of both insiders and outside investors, creating countervailing incentives when new financing is raised under asymmetric information. Our theory also entails implications for start-up and venture capital financing.