Wealth Constraints and Option Contracts in Models with Sequential Investments

• Published in: The Rand journal of economics Vol. 36; no. 4; pp. 753 - 770
• Main Author: Lulfesmann, Christoph
• Format: Journal Article
• Language: English
• Published: Santa Monica RAND 01-12-2005; Rand, Journal of Economics; Rand Corporation
• Subjects: Analysis; Contracts; Debt repayment; Economic efficiency; Financial assets; Financial economics; Financial investments; Financial models; Financing; Investment; Investments; Investors; Joint ventures; Loan defaults; Option pricing; Options contracts; Price efficiency; Pricing; R&D; Renegotiation; Repayments; Research & development; Return on investment; Sequential analysis; Stock options; Strike prices; Studies; United States
• ISSN: 0741-6261; 1756-2171

I investigate a model in which two parties A and B invest sequentially in a joint project (an asset). Investments and the asset value are nonverifiable, and A is wealth-constrained so that an initial outlay must be financed by either an agent, B (insider financing), or an external investor, a bank C (outsider financing). I show that an option contract in combination with a loan arrangement facilitates first-best investments and any arbitrary distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, I identify conditions under which the first best can still be attained. Then, either B -financing or C-financing may be strictly preferable, and a combination of insider and outsider financing may be strictly optimal.