On the Interplay of Production Flexibility and Financing Strategy

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.