The effects of the debt financing restriction in a real options model

This paper derives the firm value and the investment strategy (investment timing, debt financing, leverage, and endogenous default) when an entrepreneur makes a real investment with debt financing both in monopoly and in duopoly. In particular, we clarify the effects of the entrepreneur¿s financial constraint where a part of the investment cost must be financed by debt. The leverage and the credit spread of the constrained entrepreneur are higher than those of the unconstrained one. The investment timing of the constrained entrepreneur is later, which is consistent with the standard underinvestment theory. The financial restriction binds more tightly in duopoly than in monopoly. Surprisingly, however, in duopoly the financial constraint plays a role in moderating the preemptive competition and improving the firm value in equilibrium.