Is Operating Flexibility Harmful under Debt?

64 Pages Posted: 22 Jun 2015 Last revised: 5 Sep 2017

See all articles by Dan Iancu

Dan Iancu

Stanford Graduate School of Business

Nikolaos Trichakis

Massachusetts Institute of Technology (MIT)

Gerry Tsoukalas

University of Pennsylvania - The Wharton School

Date Written: June 1, 2015

Abstract

We study the relation between operating flexibility and the borrowing costs incurred by a firm financing inventory investments with debt. We find that flexibility in replenishing or liquidating inventory, by providing risk shifting incentives, could lead to borrowing costs that erase more than a third of the firm’s value. In this context, we examine the effectiveness of practical and widely used covenants in restoring firm value by limiting such risk shifting behavior. We find that simple financial covenants can fully restore value for a firm that possesses a mid-season inventory liquidation option. In the presence of added flexibility in replenishing or partially liquidating inventory, financial covenants fail, but simple borrowing base covenants successfully restore firm value. Explicitly characterizing optimal covenant tightness for all these cases, we find that better market conditions, such as lower inventory depreciation rate, higher gross margins or increased product demand, are typically associated with tighter covenants.

Our results suggest that inventory-heavy firms can reap the full benefits of additional operating flexibility, irrespective of their leverage, by entering simple debt contracts of the type commonly employed in practice. For such contracts to be effective, however, firms with enhanced flexibility and/or operating in better markets must also be willing to abide by more and/or tighter covenants.

Keywords: Flexibility, covenants, risk shifting, inventory management

JEL Classification: C61, G32, G33

Suggested Citation

Iancu, Dan and Trichakis, Nikolaos and Tsoukalas, Gerry, Is Operating Flexibility Harmful under Debt? (June 1, 2015). Stanford University Graduate School of Business Research Paper No. 15-39, Available at SSRN: https://ssrn.com/abstract=2621295 or http://dx.doi.org/10.2139/ssrn.2621295

Dan Iancu

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Nikolaos Trichakis (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

Gerry Tsoukalas

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
625
Abstract Views
1,431
rank
47,061
PlumX Metrics