Ebook Investment Options with Debt Financing Constraints
Firms may face debt constraints for various reasons. Exogenous debt constraints may be due for example to the compliance to minimum capital requirements set to financial institutions. Frictions due to moral hazard or asymmetric information (see Jensen and Meckling, 1976 and Myers and Majluf, 1984) may also create debt constraints. Asymmetric information can also justify why the suppliers of credit may engage in credit rationing (see for example Fazzari et al., 1988, Stiglitz and Weiss, 1981 and Pawlina and Renneboog, 2005). This study investigates the effect of debt financing constraints on firm value, the timing of investment and optimal default decision and other important variables like the credit spreads.
We use a contingent claim approach incorporating risky pre-investment R&D options and also investigate the tax raising and social welfare implications of debt financing constraints. Lensik and Sterken (2002) use a real options approach without incorporating a stochastic model for debt and optimal capital structure and discuss conditions under which credit rationing by banks may apply. We analyze the effect of exogenous debt constraints and we then also endogenize debt constraints focusing on differential information between equity and debt holders with respect to the growth rate or volatility of the underlying asset.
Rauh (2006) and Hubbard et al. (1995) show empirical evidence that firms face financing constraints that are attributed to possible debt and equity market frictions. Whited and Wu (2006) and Gomes et al. (2006) document empirically the significance of financing constraints and show that they represent a risk factor of firm returns. Boyle and Guthrie (2003) (see also Cleary et al., 2007) analyze the effect of liquidity constraints on investment decisions. Our emphasis is to explicitly consider the valuation of debt and adjustments from optimal (unconstrained) capital structure due to exogenous or endogenous debt financing constraints. We thus provide theoretical predictions using a structural model based on trade-off theory between tax benefits and bankruptcy costs. Other related work on financing constraints is that of Uhrig-Homburg (2004) that explores costly equity issue that can lead to a cash flow shortage restriction and Titman et al. (2004) that investigates the impact of financing constraints on default spreads but without modeling optimal capital structure.
Since Merton (1974) the contingent claim approach has been extended to the valuation of levered firms including the tax benefits of debt and bankruptcy costs (for example, Brennan and Schwartz, 1978, and Kane et al., 1984, and 1985). Leland (1994) uses a perpetual horizon assumption and derives closed form expressions for the value of levered equity, debt and the firm in the presence of taxes and bankruptcy costs analyzing equity holders optimal capital structure and default decisions. Leland and Toft (1996) extend Leland (1994) to allow the firm to choose the optimal maturity of the debt. Mauer and Sarkar (2005) include investment option decisions deriving closed form solutions. Gamba and Triantis (2005) consider personal and corporate taxes, capital issuance costs and liquidity constraints in a dynamic model without endogenous (optimal) default determination.
We build on Mauer and Sarkar (2005) framework and we incorporate exogenous and endogenous (due to differential information) debt constraints. We show that debt constraints reduce firm value more significantly at higher levels of competitive erosion, lower volatility of assets, higher tax rates and low bankruptcy costs situations where the net benefits of debt are more important. Adjustments to meet the constraint also depend on the optimal debt capacity at the unconstrained level and the trade-offs between foregone investment timing flexibility and the net benefits of debt. These trade-offs create a U-shape of the investment trigger with respect to the level of debt financing constraints. Finite maturity horizon for the investment option results in a decreased firm value and a more pronounced effect of the constraint. R&D growth options reduce the important impact of debt financing constraints especially for lower maturity options by enhancing option value due to an increase in expected returns or increased volatility.
We also show that R&D will increase firm value mostly by increasing the value of the option on the unlevered assets while their effect on the expected net benefits of debt is of lesser importance. We find that the exercise of R&D growth options decrease leverage ratios and expected credit spreads in the presence of constraints in contrast to the case of no constraints where R&D does not have an impact on leverage or credit spreads. We also study the effect of exogenous debt financing constraints on the level of taxes raised by the government and through a social welfare function that captures the representative firm’s value and government taxes. Our results show that there may be an optimal level of debt constraints for the overall economy under certain model parameterizations reflecting a trade-off between firm value reduction and taxes increase.
In the last part of the paper we endogenize debt constraints by introducing differential beliefs on volatility and the growth rate of assets. Our results show that when debt holders estimate of the firm’s volatility is higher or the growth rate of assets is lower than equity holders estimate, optimal leverage and firm values get reduced. These unfavourable beliefs of debt holders act as an endogenous constraint on the use of debt and create adjustments in the firm’s investment policy and capital structure. An important difference relative to the exogenous constraint case is that we no longer observe a U shape in the investment trigger with the firm delaying investment when endogenous debt constraints exist.
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