Adjustment costs and the theory of optimal investment and financing of the firm

A dynamic optimal‐control based model that explicitly includes the effects of adjustment costs of investment and financing is presented to analyse the investment and financing decisions of a present value‐maximizing firm. The model is constrained by an equity‐capital formation and a linear homogeneous earnings‐investment possibility function composed of two components: an adjustment‐cost function and an ordinary production function. Pontryagin's maximum principle is used to solve the model. The main results derived from the model include an optimal investment decision rule, an optimal investment‐financing plan, the long‐run equity demand for the firm, and the long‐run behaviour of investment and financing as they are affected by the existence of adjustment costs.