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

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 firm fs 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.