Investment options with debt-financing constraints

Abstract

Building on the Mauer and Sarker (2005) model that captures both investment flexibility and optimal capital structure and risky debt, we study the impact of debt financing constraints on firm value, the optimal timing of investment and other important variables like the credit spreads. The importance of debt financing constraints on firm value and investment policy depends largely on the relative importance of investment timing flexibility and debt financing gains. In cases where investment flexibility has high relative importance the firm can mitigate the effects of debt financing constraints by adjusting its investment policy. We show that these adjustments are non-monotonic and may create a U shape of the investment trigger as a function of the degree that debt is constrained. We show that in a reduced investment horizon, constraints have a more significant impact on firm value. We also consider managerial pre-investment risky growth options (e.g. R&D, or pilot projects). We see that they reduce the maturity effect, and (in contrast to the Brownian volatility) they tend to reduce expected credit spreads.2

Investment timing under debt issuance constraint

“…For the constrained firm with high (low) debt issuance capacity, investment thresholds are increasing (decreasing) with the debt issuance constraint. Our results are consistent with previous related papers (see, e.g., Boyle and Guthrie, 2003;Cleary et al, 2007;Koussis and Martzoukos, forthcoming).…”

A contingent claims approach to the determinants of the stock-bond return relationship

“…From a CCA perspective, our study also contributes to the recent literature that employs the predictions of the CCA to infer the effect of uncertainty on stock and bond returns and optimal capital structure decisions (see Doukas et al. 2014 andKoussis andMartzoukos 2012). …”

“…CCA is a generalization of the option pricing theory pioneered by Black and Scholes (1973) and Merton (1973), that has been applied to a wide variety of contingent claims, such as corporate bonds and equities (see Merton 1974, Galai and Masulis, 1976and Koussis and Martzoukos, 2012. In relation to our study, the CCA option pricing model suggests that that holders of risky corporate bonds can be thought of as issuers of call options to the holders of a firm's equity, where the underlying asset is the market value of the firm; the holders of the firm's equity will therefore take the residual of the firm's total asset at maturity.…”

A contingent claims approach to the determinants of the stock-bond return relationship

“…For this purpose, we re-visit the classic CCA, and use its theoretical underpinnings to infer the effects of a firm's future cash flow and business risk on the firm's stock-bond return relationship. CCA is a generalization of the option pricing theory pioneered by Black and Scholes (1973) and Merton (1973), that has been applied to a wide variety of contingent claims, such as corporate bonds and equities (see Merton 1974, Galai and Masulis, 1976and Koussis and Martzoukos, 2012. In relation to our study, the CCA option pricing model suggests that holders of risky corporate bonds can be thought of as issuers of call options to the holders of a firm's equity, where the underlying asset is the market value of the firm; the holders of the firm's equity will therefore take the residual of the firm's total asset at maturity.…”