Corporate Borrowing and Growth Option Value: The Limited Liability Effect
Jou, Jyh-Bang, Journal of Economics and Finance
A firm issues bonds before undertaking a risky continuous investment project that is costly to later either expand or contract. The firm's existing debt load causes it to install a smaller capacity because equity has limited liability. This lowers debt value, but such a cost should be borne by equityholders because debtholders will rationally anticipate equityholders' future behavior. The firm's choice of debt levels balances this agency cost against the tax shield benefit. As the firm incurs higher costs to later expand capacity, its growth option value becomes lower. The simulation results of this article are in line with Myers' conjecture (1977), which states that a firm's debt capacity is inversely related to its growth option value. (JEL G32)
Myers (1977) considers a firm that exercises the investment option after debt is in place but before debt matures. Myers assumes that the firm is concerned solely with its equityholders upon investing. This leads to a conflict of interest between equity and debt holders because equity has limited liability. Myers then reaches two conjectures. First, the firm will be more likely to pass up profitable investment projects as the firm issues more bonds, i.e., the "debt overhang" problem will arise. Second, as the firm has more growth opportunities, it will bear a larger agency cost associated with the "debt overhang" problem, and therefore, will issue fewer bonds. Myers, however, does not endogenize capital structure decision to validate his second conjecture.
To investigate the Myers second conjecture, a large volume of empirical articles use such parameters as R&D intensity and the ratio of a firm's market value to its book value to proxy growth option values (see, e.g., Bradley, Jarrell, and Kim 1984; Titman and Wessels 1988; and Smith and Watts 1992). These proxies, however, are overlooked by the theoretical literature on optimal financial structure. This article will also abstract from these proxies, but will use the proxy provided by Abel, Dixit, Eberly, and Pindyck (1996), who focus on an all-equity financed firm. Abel et al. consider how the limitations on the firm's ability to later expand or contract capacity affect its initial capacity decision. They also show that the firm's growth option value will be lower as the firm purchases capital at a higher price in the later period. By introducing both taxation and debt financing into their model, this article is able to investigate the Myers second conjecture.
This article builds a two-period model. In period 1, a firm issues bonds, followed by installing an initial capacity. After issuing bonds, the firm is acting in the interest of its equityholders. Uncertainty arises at the beginning of period 2. The purchase price of capital in period 2 is higher than its period I price, making expansion costly.2 The resale price of capital in period 2 is lower than its period I price, making contraction costly.3 After the state of nature in period 2 is realized, the firm is obliged to pay the debtors off. If this state of nature is good enough, the firm will decide whether to expand, maintain, or contract capacity and will then pay the debtors off; otherwise, the firm will go bankrupt. After bankruptcy, debtholders will control the firm and then decide a new level of capacity. Debt payments are assumed to be tax deductible with full loss offsets,4 and the costs associated with bankruptcy are ignored.5
The firm's existing debt load causes it to install a smaller capacity in period 1, thus yielding an agency cost resembling that investigated by Myers (1977). The firm's choice of debt levels balances this agency cost against the tax advantage of debt. This article then finds that if a rise in the purchase price of capital in period 2 (i.e., a lower growth option) mitigates the debt overhang problem, then debt capacity is likely to be expanded. This special case is thus in line with the Myers second conjecture. …