Resource Flexibility and Capital Structure

Abstract:     
This paper examines how the optimal investment in the capacity of flexible and nonflexible resources is affected by financial leverage and, conversely, how a firm’s resource flexibility affects its optimal capital structure. We consider a two-product firm that invests in the optimal capacity of product-flexible and product-dedicated resources in the presence of demand uncertainty. Before investing in capacity, the firm issues the optimal amount of debt, trading off the tax benefit and lower transaction cost of debt financing against the cost of financial distress and the agency cost associated with leverage.

The agency cost stems from the fact that a levered firm ignores the impact of capacity investment on the value of debt and, as a result, underinvests in capacity and chooses a less flexible capacity mix. Because this distortion of the firm’s investment strategy can be foreseen by debtholders, it increases the cost of borrowing, and thus reduces the optimal amount of debt. At the same time, flexibility reduces the risk of costly default as well as the agency cost of debt. Therefore, when the cost of flexibility is relatively low and lenders thus anticipate that the firm will choose a relatively flexible capacity mix, they should provide more favorable credit terms, to which the firm should respond by issuing more debt.

Number of Pages in PDF File: 30

Keywords: Flexibility, Capacity, Leverage, Capital Structure, Agency, Asset Substitution, Underinvestment

JEL Classification: G32

working papers series