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The effects of external financing costs on investment timing and sizing decisions

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  • Michi NISHIHARA

    ()
    (Graduate School of Economics, Osaka University)

  • Takashi SHIBATA

    ()
    (Graduate School of Social Sciences, Tokyo Metropolitan University)

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    Abstract

    We develop a dynamic model in which a firm exercises an option to expand production on either a small or large scale with cash reserves and costly external funds. We show that the financing costs greatly distort the firmfs financing and investment behavior and result in a policy contingent on the dynamics of the cash flow and reserves. Most notably, we prove that an intermediate level of cash reserves is likely to accelerate investment in the small-scale project by interactions among financing costs, investment timing, and investment sizing. Our results fill the gap between two types of results: (i) empirical findings in a U-shaped relation between the investment volume and internal funds, and (ii) empirical predictions of a U-shaped relation between the investment timing and internal funds.

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    File URL: http://www2.econ.osaka-u.ac.jp/library/global/dp/1207.pdf
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    Bibliographic Info

    Paper provided by Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP) in its series Discussion Papers in Economics and Business with number 12-07.

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    Length: 31 pages
    Date of creation: Apr 2012
    Date of revision:
    Handle: RePEc:osk:wpaper:1207

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    Web page: http://www.econ.osaka-u.ac.jp/
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    Keywords: Investment timing; Investment size; Costly external financing; Optimal stopping;

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    1. Cleary, Sean & Povel, Paul E M & Raith, Michael, 2004. "The U-Shaped Investment Curve: Theory and Evidence," CEPR Discussion Papers 4206, C.E.P.R. Discussion Papers.
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