Interest rate uncertainty and the investment/financing decisions

This paper analyzes a company's optimal investment and financing choices when both firm value and interest rates are stochastic, following the lognormal and mean-reverting processes respectively. The major new result is that the effect of interest rate on investment policy is non-monotonic, with optimal investment trigger initially increasing and subsequently decreasing in the interest rate level. This result is very different from an unlevered firm or a constant-interest-rate environment. Further, the degree of non-monotonicity increases with the volatility and long-term mean of the interest rate process. The investment trigger is also increasing in interest rate volatility and long-term mean, and initially increasing and subsequently decreasing in the speed of reversion of the interest rate process. The optimal leverage ratio is increasing in interest rate level and volatility, and decreasing in speed of reversion and long-term mean, while the effect of these parameters on optimal debt maturity period is just the opposite. We also find that the parameters of the interest-rate process (volatility, speed of reversion and long-term mean) have a larger impact on the optimal investment trigger than on the optimal leverage ratio.