Production and Capacity Management with Internal Financing
39 Pages Posted: 6 Feb 2016 Last revised: 11 Oct 2017
Date Written: April 26, 2017
Abstract
We formulate and analyze a stylized dynamic model of a price-taking firm that manages production and capacity, uses only internal financing, and faces stochastic market environments. The firm has two operationally independent production facilities, each of which makes two products, and a cash reserve which finances all operations and dividend issuance. Each period the firm chooses the amount of dividend to issue and at each facility it chooses production quantities and amounts of capacity to augment or divest. Relevant market data are exogenous and evolve stochastically. We completely characterize the optimal policy and the endogenous values of the capacities and cash reserve, and show that they invite a real-option interpretation. We find that internal financing creates a spillover between the endogenous values of the two operationally independent facilities and we specify how this leads to interdependence of their optimal policies. We show that an “invest/stay put/divest” (ISD) policy remains optimal for partially irreversible investments, but internal financing changes the ISD thresholds. If the exogenous data are intertemporally independent, an internally financed firm is less likely to issue dividends or to expand capacity than if it were in a perfect capital market. As the market becomes more volatile, the endogenous values of capacities and cash increase, and the firm becomes more reluctant to issue dividends.
Keywords: Capacity planning and investment, OM-Finance interface, real option, dynamic programming
JEL Classification: D24, D81, D92, C61
Suggested Citation: Suggested Citation