Investment Options with Debt Financing Constraints

Building on the Mauer and Sarker (2005) model that captures both investment flexibility and optimal capital structure and risky debt, we study the impact of debt financing constraints on firm value, the optimal timing of investment and other important variables like the credit spreads. The importance of debt financing constraints on firm value and investment policy depends largely on the relative importance of investment timing flexibility and debt financing gains. In cases where investment flexibility has high relative importance the firm can mitigate the effects of debt financing constraints by adjusting its investment policy. We show that these adjustments are non-monotonic and may create a U shape of the investment trigger as a function of the degree that debt is constrained. We show that in a reduced investment horizon, constraints have a more significant impact on firm value. We also consider managerial pre-investment risky growth options (e.g. R&D, or pilot projects). We see that they reduce the maturity effect, and (in contrast to the Brownian volatility) they tend to reduce expected credit spreads.