On Interactions of Production and Financial Decisions

Abstract

0 Until more than a decade ago, financial economists typically explored problems of capital structure and dividend policy under the assumption that operating cash flows or investment decisions were exogenously determined, either with certainty or with an endowed, known distribution. Micro and macro-economic theorists, on the other hand, discussed what might be called operating income maximization, and treated as irrelevant the origin of the funds they allocated between labor and capital. It is now the consensus, I believe, that although these approaches constitute important simplifications, they may obscure some of the more important activities that take place in the firm. Interactions of production and financial decisions have thus been the focus of many recent studies. This research is extremely important for financial decision makers. If indeed it turns out that there are economically significant interactions between production and financing, then proper financial management may be vastly more difficult than typically portrayed in modern textbooks. Most of what is taught in capital budgeting, for example, is based on separation of investment and financing. If in reality this is not the case, then decentralization of the firm's operations can not be maintained, and all decisions will have to be made at the same time. Indeed, the many papers described here show how investment decisions, product pricing, labor negotiations, and market power may all be significantly related to the choice of capital structure. While this survey represents an attempt to assess the economic significance of each interaction, it must be emphasized that, as a casual glance at the references should reveal, we are dealing with on-going research that is not, as yet, supported by sufficient empirical evidence to yield definitive answers.

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