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Financing long-gestation projects with uncertain demand Storey, Jim

Abstract

Financial crises in East Asia, Russia, and Latin America have caused some to wonder if there is something inherently unstable about financial markets that thwarts their ability to allocate capital appropriate^- and ultimately causes these crises. I build a multi-period, industry-level credit model in which debt-financed entrepreneurs develop homogeneous projects with long gestation periods, sequential investment requirements, and no intermediate cash flows. Entrepreneurs accumulate private signals about terminal demand, and if the signals are bad enough, may decide to halt project development before completion. The prevalence of project suspensions aggregates information and permits the industry size to adjust to the true state of terminal demand. Debt contracts depend upon the pricing power of the creditor; these contracts impact the size of the industry and the timing of the information aggregation. When demand realisations are poor, some investors will be disappointed ex post; aggregate disappointment will depend upon how long the investment behaviour has carried on before suspensions occur, and how large the industry is. I interpret situations of substantial aggregate disappointment as a 'crisis'. Principal results relate to the impact of debt finance on the timing and likelihood of project suspensions. With all equity (self) financing, suspensions will typically be observed, but they may occur relatively late in the game. In contrast, debt finance may lead to very rapid suspensions, depending upon the tools allocated to the creditor. When creditors exercise monopoly control over credit allocation and pricing, profit-maximising creditors can and will force suspensions. This may involve reducing the entrepreneurs' equity contribution and / or subsidizing credit in order to ensure entrepreneurial participation. When credit markets are competitive, creditors lack the pricing power that can be used to structure credit policies that force early suspensions. As debt accumulates and the entrepreneurs' share of liquidation proceeds dwindles, entrepreneurs may not voluntarily suspend operations as this will lead to loss of private benefits. Therefore, there may be no suspensions observed in equilibrium. This problem will be particularly acute when the entrepreneurs' initial equit)' stake is small.

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