Investment , Liquidity , and Financing under Uncertainty ∗

We develop a model of investment under uncertainty for a firm facing external financing costs. Such a firm prefers to fund its investment through internal funds, so that the firm’s optimal investment policy and value now depend on the size of its retained earnings. We show that the standard real options results are significantly modified when there are external financing costs. Importantly the investment hurdle is highly non-monotonic in the firm’s internal funds: when these are sufficient to cover capital expenditures then the investment hurdle is decreasing in the size of internal funds. But when they fall short then the firm’s investment policy becomes more and more conservative when it accumulates cash, as it has stronger incentives to postpone its investment until the point where it has sufficient internal funds to entirely cover its investment outlays. With multiple rounds of options, a financially constrained firm may choose to over-invest in order to mitigate under-investment problems in the future due to financial constraints. Our analysis brings out the subtle interactions between sources of funds (external, internal, and prospective retained earnings once the investment is undertaken) and the optimal timing of investment. ∗First draft: December, 2012. We thank Ilona Babenka, Martin Cherkes, Sudipto Dagupta, Peter DeMarzo, Mark Gertler,Vicky Henderson and seminar participants at Columbia, HKUST 2013 Finance Symposium, 2014 American Finance Association (AFA) meetings in Philadelphia, and Zhejiang University for helpful comments. †Columbia University, NBER and CEPR. Email: [email protected]. Tel. 212-854-9245. ‡Columbia Business School and NBER. Email: [email protected]. Tel. 212-854-3869. §The School of Finance, Shanghai University of Finance and Economics (SUFE). Email: [email protected].