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The non-neutrality of debt in investment timing: a new NPV rule

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  • Tarun Sabarwal

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Abstract

Limited liability debt financing of irreversible investments can affect investment timing through an entrepreneur's option value, even after compensating a lender for expected default losses. This non-neutrality of debt arises from an entrepreneur's unique investment opportunity, and it is shown in a standard model of irreversible investment that includes the equilibrium effect of a competitive lending sector. The analysis is partial, in that it takes as exogenously given an entrepreneur's use of debt. Intuitively, limited liability lowers downside risk for the entrepreneur by truncating the lower tail of risks, and lowers the investment threshold. Compensating the lender for expected default losses reduces project profitability to the entrepreneur, and increases the investment threshold. The net effect is negative, because lower downside risk has an additional impact on the option value of delaying investment. The standard NPV rule in real options theory implicitly assumes debt to be neutral. With non-neutrality of debt, an investment threshold is higher than investment cost, but lower than the standard NPV rule. Comparisons with other standard investment thresholds show similar relationships.

(This abstract was borrowed from another version of this item.)

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File URL: http://hdl.handle.net/10.1007/s10436-005-0016-9
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Bibliographic Info

Article provided by Springer in its journal Annals of Finance.

Volume (Year): 1 (2005)
Issue (Month): 4 (October)
Pages: 433-445

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Handle: RePEc:kap:annfin:v:1:y:2005:i:4:p:433-445

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Web page: http://www.springerlink.com/link.asp?id=112370

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Keywords: Debt; Default; Limited liability; Investment; NPV; Option value; G00; D92; E50;

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Cited by:
  1. Laura Delaney & Jacco J.J. Thijssen, . "Valuing Voluntary Disclosure using a Real Options Approach," Discussion Papers 11/13, Department of Economics, University of York.
  2. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, vol. 6(3), pages 295-315, July.
  3. Kit Wong, 2010. "On the neutrality of debt in investment intensity," Annals of Finance, Springer, vol. 6(3), pages 335-356, July.
  4. Yishay D. Maoz, 2005. "More on Bernanke's “Bad News Principle”," General Economics and Teaching 0510002, EconWPA.

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