Optimality of project financing: Theory and empirical implications in finance and accounting |
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Authors: | Teresa A John Kose John |
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Institution: | (1) Leonard N. Stern School of Business, New York University, 10003 New York, NY |
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Abstract: | During the 1980s a fairly active market developed in the private placement of limited recourse project financing. Although
this form of financing is gaining in importance, we know very little about it. This article presents a theoretical analysis
of project financing. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment
that are offset by the benefit of debt-related tax shields. The tradeoff specifies the optimal leverage for a firm. Within
this framework, we consider the optimality of financing a new project with a nonrecourse project financing arrangement. We
derive implications for 1) the characteristics of a new venture that will be project financed, 2) the wealth gains from project
financing over that of financing with straight debt, and 3) the optimal allocation of debt across the different assets (the
sponsor firm vs. the new venture). It is shown that a project financing arrangement, where the debt is optimally allocated
to the sponsor firm and the new venture, increases value by reducing agency costs and increasing the value of tax shields
(compared to the case of straight debt financing). The optimal allocation of debt in project financing involves assigning
to the sponsor firm and the new venture debt levels equal to their individual optimal capital structures. Several testable
empirical implications in finance and accounting are developed. |
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Keywords: | limited recourse project financing straight debt financing optimal allocation of debt |
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