Investment and leverage decisions under caps and floors

This article investigates the impact of caps and floors on investment timing and leverage decisions made by firms. By examining their effects on investment timing, firm value, leverage ratios, and credit spreads, this study sheds light on the significant implications of caps and floors. Specifically, the analysis reveals that the impact of a floor on leverage is moderate when it remains below a critical threshold. However, surpassing this threshold leads firms to issue debt with reduced risk, and potentially even risk-free debt. Consequently, the influence of the floor becomes more pronounced, leading to an acceleration of investment activities. Conversely, a lower cap acts as a deterrent to investment, contributing to increased leverage and reduced credit spreads. In a collar regime, the interaction between the floor and the cap produces non-monotonic effects, as firms gain the ability to issue risk-free debt for intermediate cap levels. Moreover, the study highlights that uncertainty consistently discourages investment, and its impact on leverage and credit spreads follows a non-monotonic pattern.