A Case Study on Pomace Olive Oil Investment-Option Valuation, Optimal Leverage and Expected Agency Costs

Abstract

Based on a case study firm whose asset is an investment option, this paper focuses on the debt financing impact and the existence of agency conflicts regarding the option exercise on optimal investment decisions, optimal capital structure and option value. The investment opportunity which is a starting project consists on extracting and refining pomace olive oil. Two sequences are considered: a crude pomace oil extraction and pomace oil refining as a second sequence. The duration of each sequence is 20 semesters of which two semesters correspond to development phase and the commercialization spreads on 18 semesters from 1997 to 2006 for the initial sequence and 1998 to 2007 for the second sequence. Conflicts of interest between equityholders-bondholders are managed through the optimal choice of the investment thresholds and optimal leverage. We show that debt financing may significantly distort investment decisions. Levered equityholders choose to speed up exercising the investment option when they maximize equity value instead of total firm value. This incentive reduces option value and optimal leverage and increases credit spread of risky debt. We find that expected agency costs constitute an important driver both of the optimal investment decisions and optimal capital structure. Numerical simulations illustrate how agency costs vary with the investment opportunity parameters.