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Leveraged Investments and Agency Conflicts When Prices Are Mean Reverting

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Abstract

We 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.

Suggested Citation

  • Kristoffer Glover & Gerhard Hambusch, 2012. "Leveraged Investments and Agency Conflicts When Prices Are Mean Reverting," Research Paper Series 314, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:314
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-03/QFR-rp314.pdf
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    References listed on IDEAS

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    1. Liu, Ruixue & Owen, Art B., 2006. "Estimating Mean Dimensionality of Analysis of Variance Decompositions," Journal of the American Statistical Association, American Statistical Association, vol. 101, pages 712-721, June.
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    Cited by:

    1. Kristoffer J. Glover & Gerhard Hambusch, 2014. "The trade-off theory revisited: on the effect of operating leverage," International Journal of Managerial Finance, Emerald Group Publishing, vol. 10(1), pages 2-22, January.

    More about this item

    Keywords

    investment; real option; mean reversion; agency conflicts;

    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

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