Two-stage investment, loan guarantees and share buybacks

Abstract

We consider an entrepreneur having an option to invest in a project and a potential growth investment option. The two-stage investment costs are financed by secured loans and paid by insurers respectively. We develop explicit models to describe guarantee costs, the timing and pricing of the two-stage investment options and share buyback option. We find that there exists optimal guarantee cost combination maximizing firm value. The firm value is higher and the negotiated buyback happens earlier if entrepreneurs rather than insurers initiate the buyback. The earlier the negotiated buyback, the higher the firm value; but the earlier the mandatory buyback, the less (higher) the firm value and the later (earlier) the growth investment if insurers (entrepreneurs) initiate the negotiated buyback. Debt financing has two opposite effects besides static trade-off theory: One decreases firm value because debt default makes the growth option forfeited; the other increases it by alleviating the second-stage underinvestment problem.