The agency problem, investment decision, and optimal financial structure

ISSN： 1466-4364

Source： The European Journal of Finance, Vol.10, Iss.6, 2004-12, pp. : 489-509

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Abstract

This article constructs a real options model in which a firm has a privileged right to exercise an irreversible investment project with a stochastic payoff. Supposing that the investment costs are fully sunk, a firm that exercises the investment option after debt is in place will then choose a better state to exercise this option as it issues more bonds. This debt-overhang phenomenon, however, benefits the firm since waiting is itself valuable. Accordingly, the firm will both exercise the investment option later and issue more bonds as compared with a firm that issues bonds upon exercising the investment option.