Real Options with Debt Renegotiation of Permanent Coupon Deduction

Abstract

This paper addresses a classical real options problem taking debt renegotiation into account. Shareholders have a permanent American renegotiation option for a permanent coupon deduction. We provide explicit formulas for the pricing and timing of the option to start a project, optimal capital structure and optimal debt renegotiation strategy. We produce an analytical proof for a widely-used but unverified assertion that the optimal renegotiation time is just the common default time. We provide an explicit post-renegotiation coupon rate. We show that debt renegotiation increases investment option value and accelerates investment. The renegotiation surplus increases with project risk and decreases with sunk cost. The investment thresholds and the acceleration extent of investment increase with the project risk and sunk cost. For a low renegotiation cost and a low debtholders' bargaining power, shareholders tend to invest in high-risk projects. The leverage is increasing in tax rate and decreasing in bankruptcy cost. When tax rate is at a medium or low level, the leverage with renegotiation is greater than that without renegotiation. When tax rate is very high, the opposite holds. The leverage is increasing in debtholders' bargaining power. The coupon deduction ratio decreases with debtholders' bargaining power. The surplus of shareholders due to the renegotiation is decreasing in debtholders' bargaining power and renegotiation cost. For high-risk projects, the surplus of debtholders and that of shareholders are more sensitive to renegotiation cost and debtholders' bargaining power.