Abstract

http://ssrn.com/abstract=1741284
 
 

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Resource Flexibility and Capital Structure


Jiri Chod


Boston College

Jianer Zhou


Boston College

April 20, 2012


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

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Date posted: January 16, 2011 ; Last revised: April 22, 2012

Suggested Citation

Chod, Jiri and Zhou, Jianer, Resource Flexibility and Capital Structure (April 20, 2012). Available at SSRN: http://ssrn.com/abstract=1741284 or http://dx.doi.org/10.2139/ssrn.1741284

Contact Information

Jiri Chod (Contact Author)
Boston College ( email )
140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States
Jianer Zhou
Boston College ( email )
140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States
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