Growth Options and Optimal Default Under Liquidity Constraints: The Role of Corporate Cash Balances

42 Pages Posted: 24 Aug 2011

See all articles by Attakrit Asvanunt

Attakrit Asvanunt

AQR Capital Management, LLC

Mark Broadie

Columbia University - Columbia Business School - Decision Risk and Operations

Suresh M. Sundaresan

Columbia University - Columbia Business School, Finance

Date Written: September 28, 2009

Abstract

In this paper, we develop a structural model that captures the interaction between the cash balance and investment opportunities for a rm that already has some debt outstanding. We consider a rm whose assets produce a stochastic cash flow stream. The fi rm has an opportunity to expand its operations, which we call a growth option. The exercise cost of the growth option can be financed either by cash or costly equity issuance. In absence of cash, we derive implicit solutions for equity and debt prices when the option is exercised optimally, under both rm value and equity value maximization objectives. We characterize the optimal exercise boundary of the option, and its impact on the optimal capital structure and the debt capacity of the rm. Next, we develop a binomial method to investigate the interaction between cash accumulation and the growth option. In this framework, the fi rm optimally balances the payout of dividends with the buildup of a cash balance to finance the growth option in the "good states" (i.e., high asset value states), and to provide liquidity in the "bad states" (i.e., low asset value states). We provide a complete characterization of the firm's strategy in terms of its investment and dividend policy. We find that while the ability to maintain a cash balance does not add significant value to the rm in absence of a growth option, it can be extremely valuable when a growth option is present. Finally, we demonstrate how our method can be extended to firms with multiple growth options.

Suggested Citation

Asvanunt, Attakrit and Broadie, Mark and Sundaresan, Suresh M., Growth Options and Optimal Default Under Liquidity Constraints: The Role of Corporate Cash Balances (September 28, 2009). Columbia Business School Research Paper , Available at SSRN: https://ssrn.com/abstract=1915516 or http://dx.doi.org/10.2139/ssrn.1915516

Attakrit Asvanunt

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Mark Broadie (Contact Author)

Columbia University - Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States
212-854-4103 (Phone)

Suresh M. Sundaresan

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
New York, NY 10027
United States
212-854-4423 (Phone)
212-316-9180 (Fax)

HOME PAGE: http://www0.gsb.columbia.edu/faculty/ssundaresan/

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