Optimal Investment and Financing with Macroeconomic Risk and Loan Guarantees

33 Pages Posted: 29 Jun 2017 Last revised: 20 Aug 2017

See all articles by Xiaolin Tang

Xiaolin Tang

Hunan University - School of Finance and Statistics

Zhaojun Yang

Southern University of Science and Technology - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: August 19, 2017

Abstract

We consider an entrepreneur who has no assets in place but possesses an option to invest in a project incurring a lump-sum investment cost, of which a fraction must be financed by entering into an equity-for-guarantee swap. The entrepreneur is exposed to macroeconomic risk as well as idiosyncratic risk. The former is described by a regime-switching process; the latter by a geometric Brownian motion. We derive the corporate security prices, guarantee costs, optimal investment and financing policy. Numerical analysis discovers that the entrepreneur postpones investment in boom but accelerates in recession. The optimal leverage ratio is countercyclical when the project idiosyncratic risk is low and vice versa. The swap mechanism eliminates ex-post agency conflicts between the borrowers and lenders but the conflicts of interest between the borrowers and the insurers appear, which induce inefficiencies from asset substitution and debt overhang. They are generally not so obvious in boom or if boom occurs frequently. The swap overcomes financing frictions and increases firm value as well.

Keywords: Loan Guarantees, Macroeconomic Risk, Investment and Financing, Nash Equilibrium

JEL Classification: G2, C7

Suggested Citation

Tang, Xiaolin and Yang, Zhaojun, Optimal Investment and Financing with Macroeconomic Risk and Loan Guarantees (August 19, 2017). Available at SSRN: https://ssrn.com/abstract=2994489 or http://dx.doi.org/10.2139/ssrn.2994489

Xiaolin Tang

Hunan University - School of Finance and Statistics ( email )

Shijiachong Road 109#
Changsha, Hunan 410079
China

Zhaojun Yang (Contact Author)

Southern University of Science and Technology - Department of Finance ( email )

No 1088, Xueyuan Rd.
District of Nanshan
Shenzhen, Guangdong 518055
China

HOME PAGE: http://fin.sustc.edu.cn/Case-detail-id-21.html

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