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

Michi Nishihara (), Takashi Shibata () and Chuanqian Zhang ()
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Michi Nishihara: Graduate School of Economics, Osaka University
Chuanqian Zhang: Cotsakos College of Business, William Paterson University,

No 21-13, Discussion Papers in Economics and Business from Osaka University, Graduate School of Economics

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.

Keywords: real options; borrowing constraints; capital structure; bankruptcy (search for similar items in EconPapers)
JEL-codes: G13 G32 G33 (search for similar items in EconPapers)
Pages: 22pages
Date: 2021-09
New Economics Papers: this item is included in nep-cfn
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