Three Essays in Corporate Investment and Financing

Abstract

This thesis explores the effects of three important factors on a firm's investment and financing decisions, using contingent claim structural model. The first essay investigates how implementation lag impacts investment timing for a levered firm. The main finding is that implementation lag can potentially have a substantial effect on a company’s investment trigger. A crucial determinant of the lag-investment relationship is the fraction of investment cost that has to be incurred upfront. If this fraction is small, investment trigger is a decreasing function of implementation lag and the effect can be economically significant. If this fraction is large, investment trigger can be either increasing or decreasing in lag, but the magnitude of the effect is not large. The second essay investigates how future uncertain growth opportunity impacts a firm's investment timing decision and optimal leverage ratio. The firm has an option to expand profits after the first investment. However, the exercise of the growth option depends not only on the underlying profit flow but also on the uncertain arrival of the growth opportunity. The model illustrates that such uncertainty can significantly impact the initial investment timing for unlevered firm in a non-monotonic way. For levered firm, the future growth uncertainty, along with debt overhang problem, can shape the firm’s financing decision at initial investment. The third essay shows how risk-compensating performance-sensitive debt can be used to mitigate the “overinvestment” agency problem. We show that properly designed performance-sensitive debt can add significant value relative to fixed-coupon debt, and identify the risk-compensation level that maximizes shareholder wealth. The optimal risk-compensation level is found to be smaller than that required to eliminate overinvestment; thus, it is optimal for shareholders to incur some agency cost of overinvestment.