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The Non-Neutrality of Debt in Investment Timing: A New NPV Rule

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  • Tarun Sabarwal

    (University of Texas at Austin)

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.

Suggested Citation

  • Tarun Sabarwal, 2004. "The Non-Neutrality of Debt in Investment Timing: A New NPV Rule," Finance 0410004, EconWPA, revised 23 May 2005.
  • Handle: RePEc:wpa:wuwpfi:0410004 Note: Type of Document - pdf; pages: 20
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    Cited by:

    1. Yishay D. Maoz, 2005. "More on Bernanke's “Bad News Principle”," General Economics and Teaching 0510002, EconWPA.
    2. Guthrie, Graeme, 2005. "Missed Opportunities: Optimal Investment Timing when Information is Costly," Working Paper Series 3990, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    3. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, pages 295-315.
    4. Delaney, L. & Thijssen, J., 2011. "Valuing voluntary disclosure using a real options approach," Working Papers 11/06, Department of Economics, City University London.
    5. 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.
    6. 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.
    7. Kit Wong, 2010. "On the neutrality of debt in investment intensity," Annals of Finance, Springer, pages 335-356.

    More about this item

    Keywords

    Debt; Default; Limited Liability; Investment; NPV; Option Value;

    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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