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Investment timing and optimal capital structure under liquidity risk

Wang, Huamao, Xu, Qing, Yang, Jinqiang (2017) Investment timing and optimal capital structure under liquidity risk. European Journal of Finance, 24 (11). pp. 889-908. ISSN 1351-847X. E-ISSN 1466-4364. (doi:10.1080/1351847X.2017.1356342) (KAR id:62157)


Deterioration in debt market liquidity reduces debt values and affects firms’ decisions. Considering such risk, we develop an investment timing model and obtain analytic solutions. We carry out a comprehensive analysis in optimal financing, default and investment strategies, and stockholderbondholder conflicts. Our model explains stylized facts and replicates empirical findings in credit spreads. We obtain six new insights for decision makers. We propose a “new trade-off theory” for optimal capital structure, a new tax effect, and new explanations of “debt conservatism puzzle” and “zero-leverage puzzle”. Failure in recognizing liquidity risk results in substantially over-leveraging, early bankruptcy or investment, overpriced options, and undervalued coupons and credit spreads. In addition, agency costs are surprisingly small for a high liquidity risk or a low project risk. Interestingly, the risk shifting incentive and debt overhang problem decrease with liquidity risk under moderate tax rates while they increase under high tax rates.

Item Type: Article
DOI/Identification number: 10.1080/1351847X.2017.1356342
Uncontrolled keywords: Real options, Capital structure, Liquidity risk, Low-leverage puzzle, Stockholder-bondholder conflicts
Subjects: H Social Sciences > HG Finance
Divisions: Divisions > Kent Business School - Division > Kent Business School (do not use)
Depositing User: Huamao Wang
Date Deposited: 28 Jun 2017 08:37 UTC
Last Modified: 09 Dec 2022 00:13 UTC
Resource URI: (The current URI for this page, for reference purposes)

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