On the Interplay of Production Flexibility and Financing Strategy

52 Pages Posted: 1 Jul 2021 Last revised: 12 May 2022

See all articles by Guoming Lai

Guoming Lai

University of Texas at Austin - Red McCombs School of Business

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

Qi Wu

Case Western Reserve University, Weatherhead School of Management

Date Written: June 26, 2021

Abstract

As modern technologies have made it less costly for firms to switch on and off production in response to market changes, firms obtain more production flexibility. In this paper, we explore how the improved production flexibility impacts joint operating policies and financing decisions. We develop a dynamic model, in which the equityholders of the firm make the decisions of pausing and restarting of production, and the degree of flexibility is reflected by the switching cost.

We find that the optimal operating policy is jointly determined with the financing choice. Debt levels, not only impact tax shields and bankruptcy costs but also the utilization of production flexibility. Debt induces risk shifting which undermines equityholders' incentive to use flexibility. We further uncover a non-monotone relationship between production flexibility and financial leverage. When the switching cost is low, production flexibility complements the benefits of debt and thus financial leverage increases in production flexibility. As the switching cost increases into an intermediate region, the firm aggressively reduces its debt to ensure the continued usage of flexibility. However, when the switching cost exceeds a threshold, the cost of reducing leverage to maintain production flexibility becomes too high, and the firm forgoes flexibility and establishes high financial leverage.

Our paper synthesizes the mixed results in the literature on how operational flexibility affects the optimal level of debt. Our paper also highlights the fact that the actual operational flexibility adopted by a firm must be jointly determined with the financing decision and that their interaction may involve the recognition that either risk shifting avoidance or risk shifting acceptance strategies may arise.

Suggested Citation

Lai, Guoming and Ritchken, Peter H. and Wu, Qi, On the Interplay of Production Flexibility and Financing Strategy (June 26, 2021). Available at SSRN: https://ssrn.com/abstract=3874324

Guoming Lai

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)

Qi Wu (Contact Author)

Case Western Reserve University, Weatherhead School of Management ( email )

10900 Euclid Ave.
Cleveland, OH 44106
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
7
Abstract Views
220
PlumX Metrics