The interaction of debt financing, cash grants and the optimal investment policy under uncertainty

Significant progress has been made toward understanding a levered firm's optimal investment policy under uncertainty. To date, however, not much work has concentrated on the time scale trade-off and collectively held real options. We employ a game-theoretic real option model between a firm and a government to analyze the effect of uncertainty and investment stimulus in the form of cash grants on optimal investment timing, financing and investment scaling. We find that the jointly held real option between the firm and the government leads to underinvestment, regardless of whether the firm has the possibility to issue debt. Subsidies, however, reduce the level of underinvestment. Notably, the results indicate that even though levered firms receive less support, they invest more than unlevered firms. This challenges recent findings that a firm's optimal investment level is not affected by the way it finances a project. Similarly, we find that for realistic parameter constellations the levered firm's optimal investment threshold can be higher than that of its unlevered counterpart. This indicates that the availability of tax shield benefits does not necessarily serve as an incentive to invest earlier. Finally, we show that the effect of cash flow uncertainty on the equilibrium level of grants is ambiguous and triggers the switch from a subsidy to non-subsidy regime.