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http://ssrn.com/abstract=2178266
 
 

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Optimal Operating Capacity and Risk with Real Options and Financial Frictions


Praveen Kumar


University of Houston - Department of Finance

Vijay Yerramilli


University of Houston, C. T. Bauer College of Business

July 2014


Abstract:     
We analyze the dynamic capacity investment decisions of a firm that is subject to financial distress costs but can hedge its risks using fixed-price operating contracts. In equilibrium, the firm may optimally choose to remain unhedged when its real option is highly valuable, that is, when demand uncertainty is high and capacity adjustment costs are low. The firm may prefer to remain unhedged at high levels of uncertainty even as distress costs increase, because it can endogenously lower its expected distress costs by reducing its operating capacity and financial leverage. We highlight the substitutability between financial and operating risk.

Number of Pages in PDF File: 50

Keywords: Real options; financial frictions; capacity; operating risk; hedging; financial risk

JEL Classification: G31, G32, D23, D24, L14

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Date posted: November 20, 2012 ; Last revised: September 11, 2014

Suggested Citation

Kumar, Praveen and Yerramilli, Vijay, Optimal Operating Capacity and Risk with Real Options and Financial Frictions (July 2014). Available at SSRN: http://ssrn.com/abstract=2178266 or http://dx.doi.org/10.2139/ssrn.2178266

Contact Information

Praveen Kumar
University of Houston - Department of Finance ( email )
Houston, TX 77204
United States
713-743-4770 (Phone)
713-743-4789 (Fax)
Vijay Yerramilli (Contact Author)
University of Houston, C. T. Bauer College of Business ( email )
Houston, TX 77204
United States
713-743-2516 (Phone)
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