Investment timing and capital structure with loan guarantees

- We derive closed-form solutions for the interaction of optimal investment and financing.
- There is an U-shaped relationship between investment timing and the coupon payment.
- The swap delays investment.
- Debt overhang and asset substitution are related to the guarantee cost.

The equity-for-guarantee swap (EGS) is a new popular financial derivative. We derive closed-form solutions for the interaction of the optimal investment and financing with the swap in a real-options framework. We find that there is an U-shaped relationship between investment timing and the coupon payment. In contrast to the classical model, EGS induces different investment and financing strategies. In particular, it delays investment. Whether the swap leads to debt overhang distortion depends on guarantee cost and the profitability of the project but it induces the borrower's risk-shifting incentive. The larger the guarantee cost, the stronger the incentive.