Strategic debt service and investment decisions

Abstract

Firms alter investing decisions when there is debt in the capital structure. Security design features can exacerbate the situation. This article studies how strategic debt service may affect investment distortions resulting from debt financing in a dynamic framework. When the production decision involves an expansion option, the shareholders’ option to strategically default on the outstanding debt eliminates bankruptcy costs but, in contrast to previous literature where production decisions are fixed, leads to suboptimal investing decisions. This is due to higher wealth transfers from shareholders to debt holders upon exercise of the growth option. Strategic debt service, therefore, may reduce the value of the firm. The setting of an endogenous production set offers a potential explanation for empirical observations of wide credit spreads and low leverage.

Acknowledgements

The author would like to thank Jerome Detemple, Nalin Kulatilaka, and Mark Loewenstein for their helpful comments. In addtion, this study has benefitted from seminars at Boston University and Ling Tung University. Any remaining errors are the auhtor's own.

Notes

¹ Brennan and Schwartz (1984), Mello and Parsons (1992), Mauer and Triantis (1994) and Mauer and Ott (2000) develop dynamic frameworks to examine the investment-financing linkage.

² Fan and Sundaresan (2000) assume renegotiation to be costless.

³ Black and Scholes (1973) and Merton (1973) developed a contingent-claim pricing method for pricing equity and debt in a dynamic setting and gave rise to many subsequent articles extending the initial results. This strand of models such as Leland (1994) commonly specifies the value of firms exogenously and precludes the possibility of exploring the incentive effects of the capital structure since the value of firms is given.

⁴ Entrepreneurs differ from hired managers in that they are indispensable for the firm's daily operating by adding value to the firm perpetually. In the context, the entrepreneur is defined as a person who has human capital that is essential for the existence of the growth option.

⁵ A now-or-never investment opportunity is the same as an investment option expiring immediately after its inception. This allows us to ignore the timing problem of the initial investment and avoid unnecessary complication in the model.

⁶ Personal taxes are ignored in the model.

⁷ It is well known that ln M_t is normally distributed (with mean ln M ₀ + (μ − 0.5σ²)t and variance σ² t) and E(M_t |M ₀) = M ₀ eμt.

⁸ See e.g. Karatzas and Shreve (1991, Ch. 1).

⁹ The expected value of cash flows discounted back to time t is .

¹⁰ The expected value of cash flows discounted back to time t is .

¹¹ Other recent articles such as Grenadier (1996), Trigeorgis (1996) and Fries et al. (1997) have contributed to the theory of real options along this line.

¹² Please refer to Dixit and Pindyck (1994) for more details and proofs.

¹³ The interpretation is consistent with the spirit of Hart and Moore (1994).

¹⁴ In contrast, the agency problem of underinvestment can be mitigated by allowing renegotiation prior to formal default if the bargaining power for equity holders increases after the investment. This can be the case when other bankruptcy costs are assumed and the total deadweight loss at default widens after the investment.

¹⁵ S0(M) can be solved numerically in the model. The result will not be presented in the article because it is out of the scope of this study.

¹⁶ Comparative statics shows that the agency cost increases with the value of η. That is, high bargaining power of equity holders exacerbates investment distortion.

¹⁷ It is reasonable to assume that in most cases deadweight loss of an intangible growth opportunity is larger than the liquidation cost of a tangible asset upon default.