Real option with liquidity constraints under secondary debt illiquidity risk market

- Our model extends the classical real investment and financing model by incorporating illiquidity risk subject to the secondary debt.
- Our model shows that the optimal coupon is a U-shaped function of internal liquidity.
- Our theoretical predictions about relationship between leverage and liquidity are supported by empirical evidence.

We incorporate the illiquidity risk subjects to the secondary debt markets into the real option framework with liquidity financing constraints. Our model shows that the investment threshold and optimal leverage no longer monotonically increase in project risk but are up to internal liquidity, and illiquidity risk will make the firm care more about the liquidity constraints. The optimal coupon shows a “U-shaped” function of internal liquidity. The optimal debt pricing depends on either coupon payment or project value, which bases on the internal liquidity. Finally, our model gives an alternative explanation for the long-time unconcluded findings of the relationship between leverage and liquidity in empirical studies.