Abstract
We provide a simple model of investment by a firm funded with debt and equity and empirical evidence to demonstrate that, once we control for the debt overhang problem with credit spreads, asset volatility is an unambiguously positive signal for investment, while equity volatility sends a mixed signal: Elevated volatility raises the option value of equity and increases investment for financially sound firms, but exacerbates debt overhang and decreases investment for firms close to default. Our study provides a simple unified understanding of the structural and empirical relationships between investment, credit spreads, equity versus asset volatility, leverage, and Tobin's .