Entry and Exit of Leveraged Investments : The Effects of Risky Debt on Investment Decisions
We create a real options model of leveraged investments to examine the effects of risky debt on investments and disinvestments (defaults). An investor finances a fraction of the investment cost with debt newly issued at the time of investments. The zone between investment trigger and disinvestment trigger is determined by the equity investor who has both the investment option and the disinvestment option.
The zone between two triggers shrinks with leverage. The leveraged investor brings the disinvestment trigger forward; the value of waiting to disinvest is more valuable with risky debt. The leveraged investor also moves the investment trigger forward because the equity maximizer takes no account of the value of waiting for a lender. The leveraged investor seeks a lower uncertainty premium; with leverage, the investor considers less amount of equity investment even though the investor assumes the financial risks. On the other hand, safe debt implies no real effects on the investment decisions.
Keywords: Hysteresis; Leverage; Real Option; Agency Problem
