On the Cost of Capital of Inventory Models with Deterministic Demand

International Journal of Production Economics, Volume 183, Part A, Pages 14-20, January 2017 DOI/10.1016/j.ijpe.2016.10.007

Mays Business School Research Paper No. 3000923

23 Pages Posted: 18 Jul 2017 Last revised: 26 May 2018

See all articles by Alejandro Serrano

Alejandro Serrano

MIT Zaragoza International Logistics Program

Rogelio Oliva

Mays Business School, Texas A&M University

Santiago Kraiselburd

MIT Zaragoza International Logistics Program; INCAE Business School

Date Written: August 4, 2016

Abstract

In the operations management literature, the financial risk in an inventory model is usually assumed to be captured by the (constant) weighted average cost of capital (WACC) of the firm. This assumption is, at best, an approximation, since this cost depends on the risk of the cash flows, which, in turn, depends on the inventory policy. We investigate what the right cost of capital should be in an inventory model with deterministic demand. To do so, we study an inventory model with a generic inventory cost function where risk depends on the inventory decision made. Additive and multiplicative financial noise functions are included to assess the impact of these on both the cost of capital of the firm and the optimal inventory policy. We find that, in contrast to previous models, risk is not in general a monotone function of inventory. Also, a rate close to the risk-free rate, which typically deviates significantly from the WACC, should be used to value inventory-related investments when the inventory cost function is dominated by holding cost for large order quantities, even if investments are subject to other sources of financial variability.

Keywords: Supply Chain Management, Risk, Operations Management-Finance Link, Cost of Capital

Suggested Citation

Serrano, Alejandro and Oliva, Rogelio and Kraiselburd, Santiago, On the Cost of Capital of Inventory Models with Deterministic Demand (August 4, 2016). International Journal of Production Economics, Volume 183, Part A, Pages 14-20, January 2017 DOI/10.1016/j.ijpe.2016.10.007; Mays Business School Research Paper No. 3000923. Available at SSRN: https://ssrn.com/abstract=3000923

Alejandro Serrano

MIT Zaragoza International Logistics Program ( email )

C/ Bari 55
Edificio Náyade 5 (PLAZA)
Zaragoza, Zaragoza 50197
Spain

Rogelio Oliva (Contact Author)

Mays Business School, Texas A&M University ( email )

430 Wehner
College Station, TX 77843-4218
United States

Santiago Kraiselburd

MIT Zaragoza International Logistics Program ( email )

Avenida Gomez Laguna 25
Zaragoza, 50009
Spain

INCAE Business School

Alajuela
Costa Rica

HOME PAGE: http://www.incae.edu

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