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Investment timing and optimal capital structure under liquidity risk

Wang, Huamao; Xu, Qing; Yang, Jinqiang

Investment timing and optimal capital structure under liquidity risk Thumbnail


Qing Xu

Jinqiang Yang



© 2017 Informa UK Limited, trading as Taylor & Francis Group. Deterioration in debt market liquidity reduces debt values and affects firms' decisions. Considering such risk, we develop an investment timing model and obtain analytic solutions. We carry out a comprehensive analysis in optimal financing, default, and investment strategies, and stockholder–bondholder conflicts. Our model explains stylized facts and replicates empirical findings in credit spreads. We obtain six new insights for decision makers. We propose a ‘new trade-off theory’ for optimal capital structure, a new tax effect, and new explanations of ‘debt conservatism puzzle’ and ‘zero-leverage puzzle’. Failure in recognizing liquidity risk results in substantially over-leveraging, early bankruptcy or investment, overpriced options, and undervalued coupons and credit spreads. In addition, agency costs are surprisingly small for a high liquidity risk or a low project risk. Interestingly, the risk shifting incentive and debt overhang problem decrease with liquidity risk under moderate tax rates while they increase under high tax rates.

Journal Article Type Article
Acceptance Date Jun 22, 2017
Online Publication Date Jul 26, 2017
Publication Date Jul 24, 2018
Deposit Date Apr 7, 2020
Publicly Available Date Apr 28, 2020
Journal European Journal of Finance
Print ISSN 1351-847X
Electronic ISSN 1466-4364
Publisher Routledge
Peer Reviewed Peer Reviewed
Volume 24
Issue 11
Pages 889-908
Public URL
Publisher URL
Additional Information This is an accepted manuscript published by Taylor & Francis in European Journal of Finance on 26.07.17, available online:


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