Scandinavian Working Papers in Business Administration

Finance Research Group Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

No F-2009-04: Investment Timing, Liquidity, and Agency Costs of Debt

Stefan Hirth () and Marliese Uhrig-Homburg
Additional contact information
Stefan Hirth: Department of Business Studies, Aarhus School of Business, Postal: The Aarhus School of Business, Fuglesangs Allé 4, 8210 Aarhus V, Denmark
Marliese Uhrig-Homburg: Chair of Financial Engineering and Derivatives, Postal: Universität Karlsruhe (TH), Germany

Abstract: This paper examines the effect of debt and liquidity on corporate investment in a continuous- time framework. We show that stockholder-bondholder agency conflicts cause investment thresholds to be U-shaped in leverage and decreasing in liquidity. In the absence of tax effects, we derive the optimal level of liquid funds that eliminates agency costs by implementing the first-best investment policy for a given capital structure. In a second step we generalize the framework by introducing a tax advantage of debt, and we show that an interior solution for liquidity and capital structure optimally trades off tax benefits and agency costs of debt

Keywords: investment timing; liquidity; agency costs of debt; capital structure; real options

48 pages, May 5, 2009

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