Review of Quantitative Finance and Accounting, 25: 357–381, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.
Dynamic Models of Investment Distortions
Department of Finance, Ling Tung College, Taiwan; Visiting Faculty at School of Management,
Zhechiang University, China, Tel: +886 2 23417720, Fax: +886 2 23222668
Abstract. This paper studies the interaction between corporate ﬁnancing decisions and investment decisions in
a dynamic framework. When the production decision involves an expansion option, the ﬁrm trades off tax beneﬁts
of debt against two costs of debt ﬁnancing, namely the investment distortion related to exercise of the expansion
option and the loss of a valuable expansion opportunity if the ﬁrm defaults. The optimal capital structure is all
equity for ﬁrms with more value in growth options (or intangible assets) and tends to involve debt ﬁnancing for
ﬁrms with more value in tangible assets.
Keywords: growth options, underinvestment, debt-overhang
JEL Classiﬁcation: D81, G13, G31, G32
Modigliani and Miller (1958) used an arbitrage argument to demonstrate that corporate
ﬁnancing and investment decisions are indeed separable under perfect capital market as-
sumptions. Since then, a central question in ﬁnancial economics has been whether market
imperfections create interactions between corporate ﬁnancing and investment decisions.
Jensen and Meckling
(1976) and Myers
(1977) were among the ﬁrst to recognize strategic
relationships among mangers, shareholders and debt holders, and identify the existence
of agency costs associated with different capital structures. After that, a large amount of
literature has been devoted to the agency problems arising from the divergent interests of
owners and managers, the resulting suboptimal investment decisions induced by the sep-
aration of ownership and control, and the determinants of optimal capital structure. With
however, theoretical models examining the interaction of ﬁnancing and
investment decisions are static.
One type of agency problem is the debt overhang problem that results when existing
ﬁnancial claims give the wrong incentives to equity holders while deciding on investment
projects and, in particular, causes them to forgo proﬁtable projects. Since it is hard to
observe management forecasts of project NPV, especially for projects that are not ultimately
undertaken, it is difﬁcult to measure the importance of the agency costs quantitatively.
Mello and Parsons (1992) provided numerical simulations for assessing the agency costs
of debt in the speciﬁc case of a mining industry. The methodology adopted in this paper
is inspired by Mello and Parsons (1992), who extended the Brennan and Schwartz (1985)
contingent claims model and incorporated the incentive effect of the ﬁnancial structure, thus