Optimal Investment and Financing with Macroeconomic Risk and Loan Guarantees

24 Pages Posted: 6 Jan 2018

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: November 30, 2017

Abstract

In this paper, 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, while the latter is described by a geometric Brownian motion. We derive the corporate security prices, guarantee costs, optimal investment and financing policy. Numerical analysis demonstrates that the entrepreneur post-pones investment in a boom but accelerates it in a recession. The optimal leverage ratio is countercyclical when the project’s idiosyncratic risk is low and vice versa. The swap mechanism eliminates ex post agency conflicts between borrowers and lenders, but conflicts of interest between borrowers and insurers appear, which lead to inefficiencies from asset substitution and debt overhang. These are generally not so obvious in a boom or if a boom occurs frequently. The swap discussed here overcomes financial friction and increases firm value as well.

Keywords: Loan Guarantees, Real Options, Macroeconomic Risk, Investment And Financing, Nash Equilibrium

Suggested Citation

Tang, Xiaolin and Yang, Zhaojun, Optimal Investment and Financing with Macroeconomic Risk and Loan Guarantees (November 30, 2017). Journal of Credit Risk, Vol. 13, No. 4, 2017. Available at SSRN: https://ssrn.com/abstract=3096043

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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