Optimal Operating Capacity and Risk with Real Options and Financial Frictions
University of Houston - Department of Finance
University of Houston, C. T. Bauer College of Business
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
Date posted: November 20, 2012 ; Last revised: September 11, 2014
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