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

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  • Tarun Sabarwal

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.
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  • Tarun Sabarwal, 2005. "The non-neutrality of debt in investment timing: a new NPV rule," Annals of Finance, Springer, vol. 1(4), pages 433-445, October.
    • Handle: RePEc:kap:annfin:v:1:y:2005:i:4:p:433-445
    DOI: 10.1007/s10436-005-0016-9
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    Cited by:

    1. Guthrie, Graeme, 2007. "Missed Opportunities: Optimal Investment Timing When Information is Costly," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(2), pages 467-488, June.
    2. Delaney, Laura & Thijssen, Jacco J.J., 2015. "The impact of voluntary disclosure on a firm’s investment policy," European Journal of Operational Research, Elsevier, vol. 242(1), pages 232-242.
    3. Lawrence, Akvile & Karlsson, Magnus & Thollander, Patrik, 2018. "Effects of firm characteristics and energy management for improving energy efficiency in the pulp and paper industry," Energy, Elsevier, vol. 153(C), pages 825-835.
    4. Yulia Vymyatnina & Evgeniya Goryacheva, 2014. "Monetary Policy Rules in the Countries of the Customs Union," EUSP Department of Economics Working Paper Series Ec-05/14, European University at St. Petersburg, Department of Economics.
    5. Yishay D. Maoz, 2005. "More on Bernanke's “Bad News Principle”," General Economics and Teaching 0510002, University Library of Munich, Germany.
    6. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, vol. 6(3), pages 295-315, July.
    7. Delaney, L. & Thijssen, J., 2011. "Valuing voluntary disclosure using a real options approach," Working Papers 11/06, Department of Economics, City University London.
    8. Laura Delaney & Jacco J.J. Thijssen, "undated". "Valuing Voluntary Disclosure using a Real Options Approach," Discussion Papers 11/13, Department of Economics, University of York.
    9. Kit Wong, 2010. "On the neutrality of debt in investment intensity," Annals of Finance, Springer, vol. 6(3), pages 335-356, July.

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    More about this item

    Keywords

    Debt; Default; Limited liability; Investment; NPV; Option value; G00; D92; E50;
    All these keywords.

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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