Working Paper: NBER ID: w20610
Authors: Patrick Bolton; Neng Wang; Jinqiang Yang
Abstract: We develop an integrated theory of investment, seasoned equity offerings (SEOs), liquidation, and corporate savings under uncertainty for a financially constrained firm, which features endogenous growth options, abandonment options, and payout policies. Facing costly external financing, the firm prefers to fund its investment internally, so that its optimal policies and value depend on both its earnings fundamentals and liquidity holdings. The firm values not only real flexibility but also financial flexibility. The interaction of real and financial flexibility generates novel real options results: (1) Limited financial slack significantly erodes the value of growth & abandonment options; (2) Firms prefer projects with front-loaded cash-flows; (3) The firm's incentive to forgo costly external financing and to accumulate internal funds may cause substantial delay in investment; (4) A financially constrained firm over-invests in early stages of its life-cycle in an effort to quickly build up its cash-flow generating capacity; (5) SEOs are driven by both firm survival and growth motives. A firm in the mature phase may find itself in three mutually exclusive regions: payout, inaction, and liquidation. A firm in its growth phase may find itself in two additional regions: a region where investment is partly financed with an SEO and a region where investment is solely financed with internal funds. These regions depend on both firm savings and earnings fundamentals.
Keywords: investment; uncertainty; financial constraints; real options
JEL Codes: E22; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited financial slack (H60) | value of growth and abandonment options (J17) |
| financial constraints (H60) | investment flexibility (G11) |
| timing of cash inflows (G14) | investment decisions (G11) |
| costly external financing (G32) | investment timing (G11) |
| external equity financing (G24) | profitability (L21) |
| financially constrained firm (G32) | overinvest in early stages (G31) |