The Effects of Reversible Investment on Capital Structure and Credit Risks

Date01 May 2016
Published date01 May 2016
The Financial Review 51 (2016) 263–293
The Effects of Reversible Investment on
Capital Structure and Credit Risks
Haejun Jeon
Osaka University
Michi Nishihara
Osaka University and Swiss Finance Institute
We propose a structural model with an optimal switching of diffusion regimes that inte-
grates a wide range of investment reversibility. The default boundary and switching thresholds
are endogenously determined, and they enable us to comprehend the interrelated problems
of the investment decision, capital structure, and credit risks. We examine not only the un-
der/overinvestment but also the under/overdisinvestment. The leverage ratio decreases when
the firm has an option to invest in a reversibleproject, which can alleviate the capital structure
puzzle. Furthermore, the model significantly reduces the wide dispersion of yield spreads
depending on the credit grade of bonds.
Keywords: optimal switching, real options, reversible investment, agency problem, capital
structure, credit risks
JEL Classifications: C61, G32, G33
Corresponding author: Ohnishi Laboratory, Graduate School of Economics, Osaka University, 1-7
Machikaneyama-cho, Toyonaka,Osaka 560-0043, Japan; Phone: 81-6-6850-5277; Fax: 81-6-6850-5277;
This work was supported by JSPS KAKENHI 23310103, 26350424, 26285071 and the Ishii Memorial
Securities Research Promotion Foundation. This paper was written when Michi Nishihara was a JSPS
Postdoctoral Fellow for Research Abroad (Visiting Researcher at the Swiss Finance Institute, ´
Polytechnique F´
erale de Lausanne). The authors would like to thank the Swiss Finance Institute and
the JSPS Postdoctoral Fellowships for Research Abroad. Also, the authors are grateful to the editor and
anonymous reviewers for helpful comments.
C2016 The Eastern Finance Association 263
264 H. Jeon and M. Nishihara/The Financial Review 51 (2016) 263–293
1. Introduction
For the last few decades, a real option-based approach has been widely accepted
in corporate finance to analyze the investment decisions under uncertainty. Earlier
works examined simple strategies, such as entry and exit options (e.g., Brennan and
Schwartz, 1985; Dixit, 1989). Subsequent research adopt more sophisticated theories,
such as optimal switching, to illustrate a firm’ssequential investment decisions under
uncertainty (e.g., Brekke and Øksendal, 1994; Duckworth and Zervos, 2001; Zervos,
2003). Yet, none of these studies investigated levered firms. Little has been known
about the capital structure and credit risks in the framework of optimal switching.
Modeling default time and credit risks is another crucial theme in finance that has
been studied extensively for decades. They are usually classified into twocategories:
structural models and reduced-form models. While the latter postulates credit events
exogenously, which makes it easier for practitioners to estimate the parameters, the
former seems more attractive on theoretical grounds as it clarifies a link between
economic fundamentals and the valuation of financial claims. Structural models
originated from the seminal works of Black and Scholes (1973) and Merton (1974)
and achieved great progress thereafter. The works of Leland (1994) and Leland and
Toft (1996) make noteworthy breakthroughs by incorporating an endogenous default
boundary and an optimal capital structure.
In this paper, we incorporate the optimal switching model of Vath and Pham
(2007) into the structural model of Leland (1994) to examine the impacts of re-
versible investment on a levered firm from various angles. Equity holders choose
when to switch between two diffusion regimes in which the expected growth rate and
the volatility are different from each other. This can be read as the firm’s capacity
coordination over time. Not only can the firm expand its business by the investment,
but it can downsize the business by the sale of production facilities when the market
demand decreases significantly. It enables us to examine the interactions of the in-
vestment opportunities, capital structure, and credit risks. In particular, we investigate
the implications of the investment reversibility by introducing a wedge between the
switching costs from each diffusion regime; that is, a wedge between the purchase
and sale prices of production facilities. There has been an attempt to adopt an optimal
switching of diffusion regime in the structural models (e.g., Leland, 1998; Ericsson,
2000; Childs and Mauer, 2008; Flor, 2011) but they do not usually consider the
switching costs, which do not fit into the modeling of capacity coordination.
Despite the plethora of studies on real options, relatively little research has been
carried out on the reversibility of investment. The necessity of research on reversible
investment has been pointed out in a number of papers. For instance, Abel and Eberly
(2002) empirically tested their theoretical models1and found that about 80% of firms
in their samples sold capital in at least one year of their sample, and that these years
1Abel and Eberly (1994) and Abel and Eberly (1996) categorize the optimal rate of investment into three
regimes: positive, zero, and negativegross investment.

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