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

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 firm 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 firm 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.