Abstract
This paper considers a model of (irreversible) investment under uncertainty for a firm facing external financing costs. Such a firm prefers to fund its investment through internal funds, so that thefirm's optimal investment policy and value now depend on the size of its retained earnings. We show that the standard real options results are significantly modified when there are external financing costs. Investment and abandonment hurdles are higher in the presence of external financing costs, and most importantly the investment hurdle is highly non-monotonic in the firm's internal funds: when these are sufficient to cover capital expenditures then the investment hurdle is decreasing in the size of internal funds. But when they fall short then theirm's investment policy becomes more and more conservative when it accumulates cash, as it has stronger incentives to postpone its investment until the point where it has sufficient internal funds to entirely cover its investment outlays. Our analysis brings out the subtle interactions between sources of funds (external, internal, and prospective retained earnings once the investment is undertaken) and the optimal timing of investment.