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

  • Tarun Sabarwal

    (University of Texas at Austin)

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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Paper provided by EconWPA in its series Finance with number 0410004.

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Length: 20 pages
Date of creation: 05 Oct 2004
Date of revision: 20 May 2005
Handle: RePEc:wpa:wuwpfi:0410004
Note: Type of Document - pdf; pages: 20
Contact details of provider: Web page: http://econwpa.repec.org

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