Real Options, Financial Frictions, and the Choice Between Markets and Contracts
University of Houston - Department of Finance
University of Houston, C. T. Bauer College of Business
April 30, 2014
We study the dynamic capacity investment decisions and risk management choices of a firm that is subject to financial distress costs, but also possesses a real option to expand capacity after the resolution of its uncertainty. The firm may choose to either hedge its uncertainty through a fixed-price operating contract with a downstream firm, or expose itself to uncertain spot market prices. Although the operating contract eliminates financial distress costs, it also eliminates the firm's real option. Hence, the firm may optimally choose to remain unhedged and expose itself to the uncertainty of the market mechanism when its real option is highly valuable, that is, when demand uncertainty is high and capacity adjustment costs are low. Surprisingly, the dominance of the market mechanism for high levels of uncertainty continues to hold even when distress costs are high, because the firm endogenously lowers its expected financial distress costs under the market mechanism by reducing its initial capacity and financial leverage.
Number of Pages in PDF File: 47
Keywords: Real options; financial frictions; hedging; operating contracts; market mechanism; capacity
JEL Classification: G31, G32, L11, L14, L22working papers series
Date posted: November 20, 2012 ; Last revised: May 2, 2014
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