Corporate Investment and Financing Policies for Innovative Growth Opportunities

Description

At a time of constant changes in technologies and consumer tastes, corporate growth opportunities, innovations for instance, tend to arise more or less independent of the firm's extant operations and have a good chance of becoming obsolete in the near future. We propose a model that incorporates these realistic features of growth opportunities which also generalize the assumptions about growth opportunities in traditional models, and analyze the firm's optimal investment and financing policies in this more general and realistic setting.Unlike a typical firm in the prior literature which can time the exercise of a growth option with ample freedom and therefore only invests in a growth opportunity when its profitability is sufficiently high, the firm facing innovative growth opportunities may be more constrained in timing the investment. Uncertain about when a growth opportunity will arrive and unwilling to lose it to obsolescence after its arrival, the firm may choose to exercise a growth option as long as there is modest profitability. This more aggressive investment policy implies that financing the investment with debt can be costly. Thus, the firm may want to use equity to finance the investment upfront and wait until its profitability is sufficiently high to restructure its capital with more debt, giving rise to a timing inconsistency between investment and debt financing.This timing inconsistency can offer new explanations to a number of empirical findings, such as firms’ tendency to finance growth opportunities with equity, especially among small and growth firms; leverage increases without capital expenditures; more pronounced stock underperformance after equity offerings than debt offerings; and prolonged debt conservatism. Importantly, the timing inconsistency is an endogenous choice of the firm based on general and realistic assumptions about innovative growth opportunities, and is not observed in traditional models where the firm is bound to have enough debt capacity to finance investment given that growth options are not subject to obsolescence and therefore are always exercised deep in the money.