TY - JOUR

T1 - R&D Investment timing, default and capital structure

AU - Bragoli, Daniela

AU - Cortelezzi, Flavia

AU - Giannoccolo, Pierpaolo

AU - Marseguerra, Giovanni

PY - 2020

Y1 - 2020

N2 - This paper investigates the interaction between R&D investment timing, probability of default, and capital structure. In particular we are interested in studying the investment behaviour of three different types of firms according to their capital structure: firms that only use internal funds as a source of funding (unlevered), firms that use debt and that are able to attract unlimited amount of funds (levered unconstrained) and finally firms that use debt, but are not able to attract all the amount needed (levered constrained). We consider irreversible investments in R&D with uncertain returns, financed through debt. We show that debt financing (with or without constraints) significantly alters the standard results in the real option literature. First, we show that leverage distorts the investment threshold and shareholders of a levered firm tend to accelerate investment with respect to an all equity financed firm. This finding is explained by the fact that the increase in the probability of default, which is positively correlated with leverage, might induce a potential loss of the investment option and thus reduce the value of the option to wait providing equity holders
with an incentive to speed up the investment. Second, if we introduce the financial constraint,
the investment threshold is characterized by a U-shaped relation. The latter implies
that the investment threshold diminishes as the financial constraint becomes less stringent,
but up to a certain minimum value. After a certain amount of leverage the firm attitude
towards R&D investment changes. The firm becomes more risk adverse, given the much
higher probability of default (linked to a much higher leverage in its balance sheet).

AB - This paper investigates the interaction between R&D investment timing, probability of default, and capital structure. In particular we are interested in studying the investment behaviour of three different types of firms according to their capital structure: firms that only use internal funds as a source of funding (unlevered), firms that use debt and that are able to attract unlimited amount of funds (levered unconstrained) and finally firms that use debt, but are not able to attract all the amount needed (levered constrained). We consider irreversible investments in R&D with uncertain returns, financed through debt. We show that debt financing (with or without constraints) significantly alters the standard results in the real option literature. First, we show that leverage distorts the investment threshold and shareholders of a levered firm tend to accelerate investment with respect to an all equity financed firm. This finding is explained by the fact that the increase in the probability of default, which is positively correlated with leverage, might induce a potential loss of the investment option and thus reduce the value of the option to wait providing equity holders
with an incentive to speed up the investment. Second, if we introduce the financial constraint,
the investment threshold is characterized by a U-shaped relation. The latter implies
that the investment threshold diminishes as the financial constraint becomes less stringent,
but up to a certain minimum value. After a certain amount of leverage the firm attitude
towards R&D investment changes. The firm becomes more risk adverse, given the much
higher probability of default (linked to a much higher leverage in its balance sheet).

KW - capital budgeting

KW - debt financing constraint

KW - real options

KW - capital budgeting

KW - debt financing constraint

KW - real options

UR - http://hdl.handle.net/10807/131700

U2 - 10.1007/s11156-019-00807-6

DO - 10.1007/s11156-019-00807-6

M3 - Article

SN - 0924-865X

VL - 54

SP - 779

EP - 801

JO - Review of Quantitative Finance and Accounting

JF - Review of Quantitative Finance and Accounting

ER -