Capacity Planning Under Uncertainty and the Cost of Capital

Posted: 17 Jul 2017

See all articles by David Johnstone

David Johnstone

University of Sydney Business School; Financial Research Network (FIRN)

Alfred Wagenhofer

University of Graz

Date Written: June 25, 2017

Abstract

We explore how risk aversion affects optimal capacity and pricing decisions within the economic setting of Banker and Hughes (1994). A risk averse firm invests in fixed capacity and sets a product price, but can also purchase spot capacity at higher unit cost. Initial capacity and price are set by maximizing the firm’s mean-variance certainty equivalent. We find that, contrary to common intuition, optimal capacity or list prices can increase under greater risk aversion depending on exogenous fundamentals. We show how the firm’s capacity and price choices affect the economic trade-off between the mean and the risk of the firm’s uncertain payoffs. We also show that the cost of capital is affected not only by the firm’s covariance with other assets, but also by its payoff mean. The objective of minimizing the cost of capital is therefore fundamentally inconsistent with maximizing project value.

Keywords: Capital Budgeting, Pricing, Cost of Capital, Capacity Planning

JEL Classification: M41, G31

Suggested Citation

Johnstone, David and Wagenhofer, Alfred, Capacity Planning Under Uncertainty and the Cost of Capital (June 25, 2017). Journal of Management Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3000259

David Johnstone

University of Sydney Business School ( email )

Instute of Transport and Logistics Studies (C37)
The University of Sydney
Sydney, NSW 2133
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Alfred Wagenhofer (Contact Author)

University of Graz ( email )

Austria
+43 316 380 3500 (Phone)
+43 316 380 9565 (Fax)

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