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Corporate investment, financing, and exit model with an earnings-based borrowing constraint

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  • Michi NISHIHARA

    (Graduate School of Economics, Osaka University)

  • Takashi SHIBATA

    (Graduate School of Management, Tokyo Metropolitan University)

  • Chuanqian ZHANG

    (Cotsakos College of Business, William Paterson University)

Abstract

We study the effects of an earnings-based borrowing constraint (EBC) on a firm fs investment, financing, and exit decisions by developing a real options model with EBC. We highlight how EBC affects the decisions and values differently from a liquidation value-based borrowing constraint (LBC). Unlike under LBC, the firm delays investment to increase the cap of debt under EBC. Investment reversibility (or equivalently, liquidation value) does not largely affect the firm with EBC, although it greatly affects the firm with LBC. Unlike LBC, EBC loosens with higher volatility because higher volatility delays investment, which increases the cap of debt. With low investment reversibility and high volatility, EBC is preferable to LBC from a firm value perspective, and in case of financial distress, the firm goes into reorganization bankruptcy rather than liquidation bankruptcy. This also implies a positive relation between the prevalence of EBC and reorganization bankruptcy. Our results are largely consistent with empirical observations.

Suggested Citation

  • Michi NISHIHARA & Takashi SHIBATA & Chuanqian ZHANG, 2021. "Corporate investment, financing, and exit model with an earnings-based borrowing constraint," Discussion Papers in Economics and Business 21-13, Osaka University, Graduate School of Economics.
    • Handle: RePEc:osk:wpaper:2113
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    More about this item

    Keywords

    real options; borrowing constraints; capital structure; bankruptcy;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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