Capacity Investment, Production Flexibility and Capital Structure | Weatherhead School at Case Western Reserve University

Capacity Investment, Production Flexibility and Capital Structure

Capacity Investment, Production Flexibility and Capital Structure



Production and Operations Management , August 2020


Many manufacturing firms have become increasingly flexible in that they can rapidly idle and restart production in response to changing commodity prices. We study how operational flexibility in an investment opportunity alters both the timing and financing decisions in the firm. We perform this analysis in a dynamic model in which a firm has multiple debt issues and decisions are made to maximize shareholder value. Since firms with operational flexibility can temporarily shut down to avoid operational losses, they may be able to better exploit a larger tax shield by taking on more debt. On the other hand, a complete lack of flexibility commits such firms to operate even in states where operational losses occur. Increasing the default barrier by taking on more debt may be more beneficial for a rigid firm since it benefits more than the flexible firm from reducing the loss region. We explore how these two forces trade off. Even though bondholders charge a higher fair premium for debt issued by the inflexible firm, we find that the rigid firm will utilize more debt. We also show that, all things being equal, firms with operational flexibility invest earlier and use less debt. <br>Dynamic models that trade off tax shields with bankruptcy costs and ignore operational flexibility may result in theoretical leverage ratios being biased high.