Investment and Financing Options with Capital Constraints

We review and extend recent contingent claims models of capital structure. We focus on two models with analytic formulas in perpetual horizonLeland (1994) and Mauer and Sarkar (2004). We implement the investment option in both models in finite horizon with a numerical lattice while maintaining the analytic structure for the capital structure decisions in the second stage by maintaining the perpetual horizon for debt. Incorporation of the investment option itself essentially extends and generalizes Leland’s model. Using this framework we investigate two issues: the effect of capital financing constraints on both debt and new equity and the effect of managerial (equity-financed) options to enhance the value of the firm by R&D, advertising or marketing research efforts before the major investment decision takes place. In this general framework we are able to analyze when equity holders should invest to improve the investment option (control option), simply delay for more uncertainty resolution or invest early in a project that can be both equity and debt financed and may face constraints in the level of financing. Financing constraints may arise due to asymmetric information or moral hazard, affecting both optimal first stage control decisions and optimal financing, and in turn, the values of equity and debt.