Capital budgeting and risk taking under credit constraints

Abstract

Credit constraints generate a hedging motive that extends beyond purely financial decisions by also distorting the selection and operation of real investment projects. We study these distortions through a dynamic model in which collateral constraints emerge endogenously. The hedging motive can be broken down into three components: expected future productivity, leverage capacity, and current net worth. While constrained firms behave as if averse to transitory fluctuations in net worth, additional exposure to factors related to persistent productivity innovations or credit capacity fluctuations increases their value. The most constrained firms abstain from financial hedging while still distorting real decisions to reflect the hedging motive. Firm-level volatility is influenced by capital budgeting distortions, which contribute as a potential explanation for the higher volatility of lower net-worth firms.