Optimal investment strategy with debt financing under stochastic interest rates

Abstract

We study an approach that can be applied by firms' managers in order to make more effective decisions on investment and debt strategies with the consideration of fluctuating interest rates. We model by a stochastic differential equation in which the drift varies in response to expanded investment and outstanding debt. In the optimization of the investment-debt policy, we consider a continuous stochastic interest rate as a discounting factor. One of our findings is that the optimal condition to consider debt financing for investment is when the liquidity level and the liquidity drift are high while the interest rates are low. Also, there are two limiting points over the liquidity level domain whereby below the lower point and above the upper point it is not optimal to consider debt financing for investment. Over the liquidity-drift range we find a point above which debt financing is optimal and also having an interest rate below the threshold value is optimal for debt financing. The suggested approach is more suitable for managing growing firms in the developing economies where the macroeconomic effects are more intense and firms rely more on debt financing over equity financing. Firms' managers have to consider the liquidity level, liquidity drift and the interest rates before embarking in debt financing for investment, while the monetary policy makers in developing economies have to ensure low interest rates in order to favour firms' investment growth.