Investment, Uncertainty, and Liquidity

Abstract

We analyze the investment timing problem of a firm subject to a financing constraint. The threat of future funding shortfalls encourages the firm to accelerate investment beyond the level that is first-best optimal. Thus, our model highlights a new way by which costly external financing can distort investment behavior. Moreover, hedging is useful not only because it allows investment to proceed, but also because it allows investment to be delayed. These results can potentially help explain observed empirical relationships between investment and liquidity, investment and uncertainty, investment and hedging, and shareholder wealth and volatility.

Keywords: Investment timing, financing constraint, hedging, liquidity

JEL Classification: G31