Real options, agency conflicts, and optimal capital structure

Abstract We examine the impact of a stockholder–bondholder conflict over the timing of the exercise of an investment option on firm value and corporate financial policy. We find that an equity-maximizing firm exercises the option too early relative to a value-maximizing strategy, and we show how this problem can be characterized as one of overinvestment in risky investment projects. Equityholders’ incentive to overinvest significantly decreases firm value and optimal leverage, and significantly increases the credit spread of risky debt. Numerical solutions illustrate how the agency cost of overinvestment and its effect on corporate financial policy vary with firm and project characteristics.

[1]  Walter N. Torous,et al.  A comparison of financial recontracting in distressed exchanges and chapter 11 reorganizations , 1994 .

[2]  S. Kaplan,et al.  How Costly is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed , 1997 .

[3]  A. Damodaran.  Corporate Finance : Theory and Practice , 1996 .

[4]  P. Collin‐Dufresne,et al.  The Determinants of Credit Spread Changes , 2001 .

[5]  Moshe Kim,et al.  Technology, debt and the exploitation of growth options , 1990 .

[6]  John Parsons,et al.  Measuring the Agency Cost of Debt , 1992 .

[7]  S. Myers.  Determinants of corporate borrowing , 1977 .

[8]  M. C. Jensen,et al.  Harvard Business School; SSRN; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit , 1976 .

[9]  Sheridan Titman,et al.  A Dynamic Model of Optimal Capital Structure , 2002 .

[10]  P. Collin‐Dufresne,et al.  Do Credit Spreads Reflect Stationary Leverage Ratios , 2001 .

[11]  Michael R. Roberts,et al.  Are Bond Covenants Priced , 2004 .

[12]  M. Weisbach,et al.  Measuring investment distortions arising from stockholder-bondholder conflicts , 1999 .

[13]  H. Leland..  Agency Costs, Risk Management, and Capital Structure , 1998 .

[14]  Kose John,et al.  Top‐Management Compensation and Capital Structure , 1993 .

[15]  H. Leland.,et al.  Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads , 1996, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[16]  B. Gavish,et al.  On the Asset Substitution Problem , 1983 .

[17]  R. Green,et al.  Asset substitution and the agencycosts of debt financing , 1986 .

[18]  Raghuram G. Rajan,et al.  Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit‐taking , 2002 .

[19]  Amir Barnea,et al.  A RATIONALE FOR DEBT MATURITY STRUCTURE AND CALL PROVISIONS IN THE AGENCY THEORETIC FRAMEWORK , 1980 .

[20]  Jan Ericsson.  Asset Substitution, Debt Pricing, Optimal Leverage and Maturity , 2000 .

[21]  Eduardo S. Schwartz,et al.  Optimal Financial Policy and Firm Valuation , 1984 .

[22]  Interaction of Debt Agency Problems and Optimal Capital Structure: Theory and Evidence , 2003, Journal of Financial and Quantitative Analysis.

[23]  Eduardo S. Schwartz,et al.  Investment Under Uncertainty. , 1994 .