NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Investment Under Uncertainty and the Value of Real and Financial Flexibility

Patrick Bolton, Neng Wang, Jinqiang Yang

NBER Working Paper No. 20610
Issued in October 2014
NBER Program(s):Asset Pricing, Corporate Finance, Economic Fluctuations and Growth

We develop a model of investment timing under uncertainty for a financially constrained firm. Facing external financing costs, the firm prefers to fund its investment through internal funds, so that the firm's optimal investment policy and value depend on both its earnings fundamentals and liquidity holdings. We show that financial constraints significantly alter the standard real options results, with the financial flexibility conferred by internal funds acting as a complement, and at times as a substitute, to the real flexibility given by the optimal timing of investment. We show that: 1) the investment hurdle is highly nonlinear and non-monotonic in the firm's internal funds; 2) in contrast to predictions implied by standard corporate savings models, a financially constrained firm may behave in a risk seeking sense (and thus firm value may be convex in liquidity) due to the interaction between financial and real (growth/abandonment) flexibility; 3) with multiple rounds of growth options, a value-maximizing financially constrained firm may choose to over-invest via accelerated investment timing in earlier stages in order to mitigate under-investment problems in later stages.

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Document Object Identifier (DOI): 10.3386/w20610

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