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The Non-Neutrality of Debt in Investment Timing: A New NPV Rule
Sabarwal, Tarun
Sabarwal, Tarun
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Abstract
Limited liability debt financing of irreversible investments can affect investment timing
through an entrepreneur’s option value, even after compensating a lender for expected default
losses. This non-neutrality of debt arises from an entrepreneur’s unique investment
opportunity, and it is shown in a standard model of irreversible investment that is enhanced
in a straightforward manner to include the equilibrium effect of a competitive lending sector.
The analysis is partial, in that it takes as exogenously given an entrepreneur’s use of
debt. Intuitively, limited liability lowers downside risk for the entrepreneur by truncating the
lower tail of risks, thereby lowering the investment threshold. Compensating the lender for
expected default losses reduces project profitability to the entrepreneur, thereby increasing
the investment threshold. The net effect is negative, because lower downside risk has an
additional impact on the option value of delaying investment. The standard NPV rule in
real options theory implicitly assumes debt to be neutral. With non-neutrality of debt, an
investment threshold is higher than investment cost, but lower than the standard NPV rule.
Comparisons with other standard investment thresholds show similar relationships.
Description
This is the author's accepted manuscript. The original published version is available at: http://dx.doi.org/10.1007/s10436-005-0016-9.
Date
2005
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Springer Verlag
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0410004.pdf
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Keywords
Debt, Default, Limited liability, Investment, NPV, Option value
Citation
Sabarwal, Tarun (2005): “The Non-Neutrality of Debt in Investment Timing: A New NPV Rule,” Annals of Finance, 1(4), 433-445. http://dx.doi.org/10.1007/s10436-005-0016-9