Investment under Uncertainty with Strategic Debt Service

Abstract

The presence of a well designed bankruptcy code is an important part of the financialarchitecture in developed economies. By allowing the creditors to seize the assets of theborrowers who fail to make contractual payments, the code generates beneficial ex ante effectson debt capacity and firm value. By giving the borrowers options to renegotiate their debtobligations and seek bankruptcy protection, the code increases the likelihood that borrowersmay avoid inefficient ex post liquidation. As Hart (1999) notes, the code should balanceex ante firm value maximization with ex post efficiency. The bankruptcy codes in differentcountries weight this tradeoff differently and hence vary in terms of the distribution of rightsand powers between borrowers and lenders.In this paper, we provide an inter-temporal framework to examine how the creditors’liquidation rights and the distribution of ex post bargaining powers influence the firm’s in-vestment and financing decisions, and affect ex ante firm value. We show that strongerequityholders’ bargaining power lowers debt capacity, reduces firm value, and discouragesgrowth option exercising. Our calibration suggests that the quantitative effects of ex poststrategic renegotiation on ex ante firm value may be large.Our paper provides an attempt to integrate financial architecture into the theory of in-vestment (growth option exercising), by building on two strands of literature: investment anddebt pricing. We extend the real options approach to investment, pioneered by McDonaldand Siegel (1986) and Brennan and Schwartz (1985), to allow for capital structure decisionsunder strategic debt service. We also draw insights from corporate debt pricing/capital struc-ture literature, which focuses on leverage and security pricing after investment has alreadybeen made (Merton (1974), Black and Cox (1976), and Leland (1994)). Our paper bridgesthe gap between these two strands of literature by characterizing the optimal investment andfinancing decisions, and the option value of waiting in closed form. We show that the inter-action between financing and investment decisions in the presence of strategic debt servicegenerates new insights and also quantitatively important effects on ex ante firm value.