A Framework for the Study of Expansion Options, Loan Commitments and Agency Costs

24 Pages Posted: 21 Jul 2008

Date Written: July 21, 2008

Abstract

We consider a firm that operates a single plant and has an expansion option to invest in a new plant. This setup leads to two-sided optimal stopping problems. We analyze optimal expansion timing and quantify the value of the loan commitment that the equityholder obtained from the lender and associated agency costs incurred on the lender's side. Moreover, we incorporate construction period for the new plant, which throws another layer of uncertainty into the model: the parties cannot tell price level of the firm's product when the construction completes. This analysis contrasts with the conventional one-sided stopping models in corporate finance literature. We can study expansion options by viewing a firm's existing operation, bankruptcy threat, and financing decisions all together.

Keywords: Irreversible investment, bankruptcy cost, agency costs, optimal stopping, loan commitment

JEL Classification: D81, D92, G31, G33

Suggested Citation

Egami, Masahiko, A Framework for the Study of Expansion Options, Loan Commitments and Agency Costs (July 21, 2008). Available at SSRN: https://ssrn.com/abstract=1164833 or http://dx.doi.org/10.2139/ssrn.1164833

Masahiko Egami (Contact Author)

Kyoto University ( email )

Yoshida-Honmachi
Sakyo-ku
Kyoto, 606-8501
Japan

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