Investment Risk, Financial Slack, and Value of Capital: A Theoretical Examination

Abstract

Investment risk is a ubiquitous concern among entrepreneurs. In an influential paper, Albuquerque and Wang [1] show that investment risk creates the disutility effect because it is disliked by a risk-averse entrepreneur. In response, the value of installed capital rises above its replacement cost so as to induce investment. The finding of [1] is based on firms operated under autarky, which rules out the accumulation of financial reserves. By developing and solving a dynamic stochastic model that involves asset allocation, consumption, business liquidation, and investment-specific shocks, we show fundamentally different results for a firm that has built up a high degree of financial slack: The firm now gets affected by investment-specific shocks only when these shocks are correlated with the stock market. In that case, investment risk that exposes the firm more to the market simultaneously depresses corporate investment and the valuation of capital. We further show that a firm permanently cuts both its investment and the valuation of capital once it has broken out of autarky.