Optimal Investment and Financing with Macroeconomic Risk and Loan Guarantees

Abstract

We consider an entrepreneur who has no assets in place but possesses an option to invest in a project incurring a lump-sum investment cost, of which a fraction must be financed by entering into an equity-for-guarantee swap. The entrepreneur is exposed to macroeconomic risk as well as idiosyncratic risk. The former is described by a regime-switching process; the latter by a geometric Brownian motion. We derive the corporate security prices, guarantee costs, optimal investment and financing policy. Numerical analysis discovers that the entrepreneur postpones investment in boom but accelerates in recession. The optimal leverage ratio is countercyclical when the project idiosyncratic risk is low and vice versa. The swap mechanism eliminates ex-post agency conflicts between the borrowers and lenders but the conflicts of interest between the borrowers and the insurers appear, which induce inefficiencies from asset substitution and debt overhang. They are generally not so obvious in boom or if boom occurs frequently. The swap overcomes financing frictions and increases firm value as well.