Optimal Investment under Credit Constraints

Abstract

We analyze in this paper the interaction between financing and investment decisions in presence of debt issuance costs. We find that, while debt issuance costs reduce tax shields, tax shields induce a higher investment trigger. Moreover, the investment trigger is a non-monotonic function of the borrowing capacity. Indeed, as credit constraints relax, entrepreneurs with small debt capacity speed up investment to exploit tax shields, whereas those with large debt capacity postpone investment to minimize default risk.* I. Introduction The literature on investment under uncertainty has mainly focused on the consequences of ir reversibility on investment decisions. One important result highlighted is that when investment is irreversible, it is not optimal to invest the first time at which the net present value (NPV) of the project becomes positive. Instead, since waiting has a value, it is optimal to invest only when the operating value of the project reaches a critical threshold that is larger than the investment cost. Although the literature on real options has deeply analyzed the optimal timing of investment, it has so far not given enough attention to the financing decision. This paper is a contribution to the recent literature that tries to bridge the gap between investment and financing decisions. Our main objective is to analyze the impact of debt financing on the exercise of a growth option, in presence of debt issuance costs. Since the availability of funding is an important determinant of the investment level, we focus on the effect of a borrowing constraint on both the timing of investment and the value of the firm. We consider an entrepreneur who holds an option to invest in a risky project. The entrepreneur has access to credit markets but may be constrained in the amount of debt that she can obtain from creditors. Debt is attractive because of the tax deduction associated to coupon payments. Debt is a perpetual coupon bond and is fairly priced at the invest ment date. However, debt financing induces some issuance costs that reduce its tax advantage. We characterize the optimal investment and financing decisions of the entrepreneur. First, we analyze the impact of debt financing on the investment timing when the credit constraint is not binding. We find that tax shields accelerate the investment decision. In fact, since tax shields represent additional cash flows at the investment date, the option in which