Investment under Uncertainty and the Value of Real and Financial Flexibility
50 Pages Posted: 7 Dec 2013 Last revised: 28 Aug 2014
Date Written: May 27, 2014
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.
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