Corporate investment, financing, and exit model with an earnings-based borrowing constraint?

This paper develops a real options model to study the effects of an earnings-based borrowing constraint (EBC) on a firm's investment, financing, and exit decisions. We highlight how EBC affects the decisions and values differently than a liquidation value-based borrowing constraint (LBC). Unlike LBC, the firm with EBC delays investment to increase the cap of debt. Investment reversibility (or equivalently, liquidation value) does not largely affect the firm with EBC, although it greatly affects the firm with LBC. Unlike LBC, EBC loosens with higher volatility because higher volatility delays investment, which increases the cap of debt. With low investment reversibility and high volatility, EBC is preferable to LBC from a firm value perspective, and in case of financial distress, the firm will go into reorganization bankruptcy rather than liquidation bankruptcy. This also implies a positive relation between EBC and reorganization bankruptcy. Our results are largely consistent with empirical observations.