Capacity Investment, Production Flexibility, and Capital Structure

Abstract

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 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. We compare the decisions of a flexible firm, which can temporarily shut down to avoid operational losses, with those of a rigid firm which is not able to stop operating even in states where operational losses occur. On one hand, firms with operational flexibility can better exploit a larger tax shield by taking on more debt. On the other hand, taking on more debt may be less harmful for a rigid firm, since it increases the default threshold thereby reducing the region where operational losses are experienced due to inflexibility. We explore how the two forces trade off between the benefit of tax shield and the cost of default. We find that, even though bondholders charge a higher fair premium for debt issued by the inflexible firm, 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 to finance the opportunity. Dynamic models that trade off tax shields with bankruptcy costs and ignore operational flexibility may result in theoretical leverage ratios being biased high.

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