Corporate Borrowing and Growth Option Value: The Limited Liability Effect

By Jou, Jyh-Bang | Journal of Economics and Finance, Spring 2001 | Go to article overview

Corporate Borrowing and Growth Option Value: The Limited Liability Effect


Jou, Jyh-Bang, Journal of Economics and Finance


Abstract

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)

Introduction

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. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Corporate Borrowing and Growth Option Value: The Limited Liability Effect
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.