Capital Supply Uncertainty, Cash Holdings, and Investment

Abstract

We develop a model of investment, financing, and cash management decisions in which investment is lumpy and firms face uncertainty regarding their ability to raise funds in the capital markets. We characterize optimal policies explicitly and show that the smoothpasting conditions used in prior contributions are necessary, but may not be sufficient, for an optimum. Instead of the standard Miller and Orr (1966) double-barrier policy for financing and payout, firms may optimally raise outside funds before exhausting internal resources and the optimal payout policy may feature several regions, with both smooth and discrete dividend payments. In the model, firms with high investment costs are qualitatively as well as quantitatively different in their investment, financing, and payout behaviors from firms with low investment costs. Finally, investment and payout do not always increase with slack, challenging the use of investment-cash flow sensitivities or payout ratios as measures of financing constraints.

Credit market frictions and capital structure dynamics

“…While problems with a finite number of real options can be solved using backward induction (see, e.g., Hugonnier, Malamud, and Morellec [34]), the problem with infinitely many options is much more complex because the exercise value of the option depends on the (stationary) optimal exercise policy, which itself depends on the exercise value. This leads to a non-standard fixed point problem, and the contraction techniques used in the previous section are not directly applicable here.…”

“…In these papers, frictions in equity markets have been modeled either using search frictions, as in Hugonnier, Malamud, and Morellec [34], or using time-varying costs of equity financing, as in Bolton, Chen, and Wang [7]. None of these papers study frictions in debt markets.…”

Investment timing with fixed and proportional costs of external financing

“…In the integrated model, they showed that the marginal value of liquidity plays a central role in the firm's investment, financing, and payout decisions. Hugonnier, Malamud, and Morellec (2011) examined the optimal investment, financing, and dividend policies of a firm that faces uncertainty regarding its ability to raise funds. They showed that capital supply uncertainty leads to optimal corporate policies which are highly contingent on cash balance.…”

Optimal Investment Strategy under Stochastic Interest Rates

“…While they considered debt as a means to further investment, in our case we consider the collected revenue of a firm as main source of funding the investment growth. Hugonnier, Malamud and Morellec [18] developed a model of investment, financing, and cash management decisions in which investment is lumpy and firms face capital supply uncertainty.…”

“…Lemma 1. The diffusion equation presented by (18) with some given initial and boundary conditions deduced from (13) and (14) has a unique solution.…”