Investment under Uncertainty and the Value of Real and Financial Flexibility

50 Pages Posted: 7 Dec 2013 Last revised: 28 Aug 2014

See all articles by Patrick Bolton

Patrick Bolton

Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Neng Wang

Columbia Business School - Finance and Economics

Jinqiang Yang

Shanghai University of Finance and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: May 27, 2014

Abstract

We develop a model of investment under uncertainty for a nancially constrained firm. Facing external financing costs, the firm prefers to fund its investment through internal funds, so that the firm's optimal investment policy and value now depend on both its earnings fundamentals and liquidity holdings. We show that financial constraints significantly alter the standard real options results, with the financial flexibility conferred by internal funds acting as a complement, and at times as a substitute, to the real flexibility given by the optimal timing of investment. We show that: 1) the investment hurdle (whose deviation from the first-best Modigliani-Miller benchmark measures investment distortions) is highly nonlinear and non-monotonic in the firm's internal funds, as the firm may prefer accumulating internal funds rather than accessing external capital markets to finance investment when internal funds are sufficiently high; 2) with multiple rounds of growth options, a value-maximizing financially constrained firm may choose to over-invest via accelerated investment timing in earlier stages in order to mitigate under-investment problems in later stages.

Suggested Citation

Bolton, Patrick and Wang, Neng and Yang, Jinqiang, Investment under Uncertainty and the Value of Real and Financial Flexibility (May 27, 2014). Columbia Business School Research Paper No. 14-1. Available at SSRN: https://ssrn.com/abstract=2364067 or http://dx.doi.org/10.2139/ssrn.2364067

Patrick Bolton

Columbia Business School - Department of Economics ( email )

420 West 118th Street
New York, NY 10027
United States

HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Neng Wang (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

Register to save articles to
your library

Register

Paper statistics

Downloads
225
rank
123,186
Abstract Views
1,107
PlumX Metrics