"Investment Under Uncertainty with Strategic Debt Service"
American Economic Review Papers and Proceedings,
Volume: 97 | Issue: 2 | Pages: 256-61
Publication type: Journal article
We integrate the financial architecture into the theory of investment by building on two strands of literature: irreversible investment and debt pricing/capital structure. We extend the real options approach to investment, pioneered by Michael J. Brennan and Eduardo S. Schwartz (1985) and Robert McDonald and Daniel Siegel (1986), to allow for capital structure decisions under strategic debt service. We also draw insights from corporate debt pricing/capital structure literature, which focuses on leverage and security pricing after investment has already been made (Robert C. Merton 1974; Hayne E. Leland 1994). Our paper shows that the interaction between financing and investment decisions in the presence of strategic debt service generates new insights and also significant quantitative effects on ex ante firm value. We show that stronger equity holders' bargaining power lowers debt capacity, reduces firm value, and discourages growth option exercising.
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