Optimal Investment and Financing Decisions Under Cost Uncertainty

Abstract

In this paper, we employ the real options approach to study the impact of cost uncertainty on a firm’s optimal investment and financing decisions. The firm owns a perpetual right to an irreversible investment project, and the firm’s goal is to determine the optimal investment timing and level of coupon payments when the investment cost jumps upward at a random time. We find that the optimal investment threshold and level of coupon payments decrease with the jump intensity and the magnitude of the jump. The cost uncertainty gives the firm a stronger incentive to accept projects with risky cash flows. Furthermore, we examine the conflict of interests between the share- and bond-holders. We show that the debt overhang distortion and the asset substitution incentive decrease with the cost uncertainty. However, the effect of cost uncertainty on the incentive of asset substitution reverses in the region of low operating profits