Significant progress has been made toward understanding a levered firm’s optimal investment policy under uncertainty. To date, however, not much work has concentrated on the time scale trade-off and collectively held real options. We employ a game-theoretic real option model between a firm and a government to analyze the effect of uncertainty and investment stimulus in the form of cash grants on optimal investment timing, financing and investment scaling. We find that the jointly held real option between the firm and the government leads to underinvestment, regardless of whether the firm has the possibility to issue debt. Subsidies, however, reduce the level of underinvestment. Notably, the results indicate that even though levered firms receive less support, they invest more than unlevered firms. This challenges recent findings that a firm’s optimal investment level is not affected by the way it finances a project. Similarly, we find that for realistic parameter constellations the levered firm’s optimal investment threshold can be higher than that of its unlevered counterpart. This indicates that the availability of tax shield benefits does not necessarily serve as an incentive to invest earlier. Finally, we show that the effect of cash flow uncertainty on the equilibrium level of grants is ambiguous and triggers the switch from a subsidy to non-subsidy regime.

Introduction

One of the key strategic decisions in firms concerns the timing and financing of an investment. According to corporate finance theory, firms have to consider two trade-offs. First, the optimal investment timing decision is determined by the trade-off between early commitment to cash flows and late commitment to maintaining managerial flexibility. Second, the optimal leverage decision is determined by the trade-off between interest tax shield benefits and bankruptcy costs of debt in the event of default. Option-based valuation of investments has been proposed as an efficacious analytical tool for addressing these trade-offs and the literature provides guidance on how to determine the optimal investment timing of an unlevered firm under uncertainty (see, e.g., Dixit & Pindyck, 1994; Mauer & Triantis, 1994; McDonald & Siegel, 1986; Trigeorgis, 1999; Trigeorgis & Tsekrekos, 2018). These approaches have been extended to take the financing decision into account, especially debt financing by means of corporate bonds (see, e.g., Mauer & Sarkar, 2005; Shibata & Nishihara, 2012). ∗ Corresponding author. E-mail addresses: elmar.lukas@ovgu.de (E. Lukas), thiergart@embever.com (S. Thiergart). However, bonds are not the only source of financing key strategic investments. Different kinds of public support are also important sources of financing. According to a recent report by the European Commission, EU Member States granted a total amount of roughly EUR 10.9 billion to promote corporate R&D investments in 2010, which corresponds to circa 18 percent of total aid for industry and services.1 Besides tax credits, the most common types of governmental support are cash grants and infrastructure assistance (e.g., site procurement and preparation). One program that offers such cash grants is the Texas Enterprise Fund (TEF). Since its creation in 2004, it has awarded over 140 cash grants to levered multinationals such as Apple Inc., eBay, Lockheed Martin, Samsung and T-Mobile totaling nearly $600 million for investment projects (see Table 1).