Leveraged Investments and Agency Conflicts When Prices Are Mean Reverting
AbstractWe analyse the effect of differing uncertainty assumptions on the costs of shareholder-bondholder conflicts arising from partially debt-financed investments. A partial equilibrium model, valid for a large class of diffusion processes, is developed and then applied to the specific cases of a geometric Brownian motion (GBM) and a mean-reverting (MR) process. This allows for the comparison of the two scenarios and contributes to the ongoing discussion on the effects of mean reversion on investment and financing behaviour. We find that agency costs are much lower under MR dynamics and, through the application of a novel agency cost decomposition, we show that for a high expected growth in future profits (high growth GBM) agency costs are driven mainly by suboptimal financing decisions, as opposed to suboptimal (default and investment) timing decisions. The situation is reversed for lower growth assumptions and for an increase in the speed of mean reversion. Our results on the components and drivers of agency costs are valuable to both policy makers and regulators alike.
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Bibliographic InfoPaper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 314.
Date of creation: 01 Sep 2012
Date of revision:
investment; real option; mean reversion; agency conflicts;
Find related papers by JEL classification:
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
- G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-13 (All new papers)
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