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PII: S0377-2217(17)30186-8
DOI: 10.1016/j.ejor.2017.02.042
Reference: EOR 14284
Please cite this article as: Jian NI , Lap Keung CHU , Qiang LI , Capacity Decisions with Debt Fi-
nancing: The Effects of Agency problem, European Journal of Operational Research (2017), doi:
10.1016/j.ejor.2017.02.042
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Highlights:
We investigate the agency issue in a capacity planning problem under debt financing.
We show that the agency problem will substantially affect the optimal decision.
The agency cost can remain significant despite a low expected bankruptcy cost.
Firms can control the agency cost with an effective financial hedging.
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problem
Jian NI
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School of Finance, Southwestern University of Finance and Economics
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Chengdu 611130, China
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Tel.: +86 13980713976.
E-mail: kevinni0326@outlook.com
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Lap Keung CHU
E-mail: lkchu@hkucc.hku.hk
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E-mail: liqiang@connect.hku.hk
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Abstract: This paper studies the capacity management problem for a firm that uses debt
financing. This is done by analyzing the effect of the associated agency problem when making
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capacity decisions. The agency problem arises when there are potential conflicts of interest
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between the firm owner and the lender. We show that this agency problem can constrain the
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firms optimal capacity decision, because the borrowing rate will increase as the risk of default
increases with capacity level chosen. The firm will therefore try to optimally choose the level so
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as to reduce the risk of bankruptcy, which the lender will take into account, and as a consequence
the firm will try to control the risk associated with potentially high borrowing costs. However,
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even when the expected bankruptcy cost is carefully controlled, the optimal capacity decision is
still made at the risk of incurring considerable agency costs. In addition, the corporate tax level
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can also play a significant role in capacity choice. We show that although a higher tax rate leads
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to bigger tax benefit of debt and lower agency cost, it also gives rise to a higher tax liability.
After balancing the tax benefit of debt with the agency cost, the firm can make an optimal
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decision on the capacity level required. The efficacy of financial hedging for mitigating the
agency cost is also analyzed. Finally, we compare and contrast our analysis with existing studies,
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and it appears that we have been able to obtain a deeper insight into the problem.
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Keywords: Decision analysis; Capacity decision; Debt financing; Conflicts of interest; Agency
cost
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1. Introduction
Capacity management is a critical business decision for the all firms that need to accommodate
to a changing market environment for their products or services. It will typically involve
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related business operations. However, capacity planning in practice is not a simple task. It is
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extensively reported in the capacity management literature (Van Mieghem 2003) that the main
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difficulty in making an optimal capacity choice is that managers are generally uncertain about
future market prices and demand of the their products. Another difficulty, which is not
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uncommon in practice and which has remained largely unexplored in the literature, is that a firm
with limited funds may need to resort to outside financial sources to enable it to achieve an
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optimal level of capacity investment. Such a firm will need to borrow money from one or more
outside lenders to fund a capacity expansion program. Traditional lenders such as the
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commercial banks will obviously prefer to offer loans to large firms with sufficient assets that
can serve as collateral for the loans. It follows that it is the small firms are more likely to be
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financially constrained when making capacity investment in order to take advantage of growth
opportunities. Fortunately, recent advances in finance such as internet banking (Xue et al. 2011)
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and supply chain finance (Chen and Cai 2011) have given small firms opportunities to apply
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A primary concern on using the debt financing in capacity investment, however, is that the
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borrowing rate would be high. At the first glance, the potential high borrowing cost might be due
to the high risk of a firm. But if we look deeper, there should be an agency problem playing an
important role (Leland 1998). The agency problem arises from the conflicts of interest between
the firm owner (equity holder) and the lender (debt holder): The firm owner has only limited
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liability, but can enjoy any excessive profit after fulfilling the debt service; in contrast, the lender
of the firm just earns a fixed income, but could lose all of its money if the firm goes under. Thus,
the lender may have the concern that the firm owner would use the borrowed money to bet on
highly risky investment, because if the investment is successful, the excessive profit is not shared
by the debt holder, but if the investment fails, there would be significant loss for the debt holder.
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In other words, the agency problem arises from the fact that the lender shares the risk, but not the
excessive profit of the firm owner. Although the Modigliani-Miller theorem (Modigliani and
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Miller 1958) suggests a higher leverage would increase expected equity returns in the absence of
the agency cost, the pecking order theory (Brealey et al. 2008) suggests that the agency problem
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is a key issue that can substantially affect the effectiveness of debt financing. In fact, several
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empirical studies (e.g., Shyam-Sunder and Myers 1999, Fama and French 2002) have found
evidences in support of the pecking order theory, which further confirms the critical role of
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agency problem in using debt capital. Therefore, it is necessary for the firm owner to
contemplate the agency problem associated with debt financing when making capacity
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investment decisions. As will be shown, it is the agency problem that will significantly shape the
In this paper, we study the capacity decision of a firm with debt financing, showing that how
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the aforementioned agency problem should affect the optimal capacity choice of the firm. We
start by analyzing a basic model in which the market uncertainty follows a binary distribution.
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The optimal capacity level, the borrowing rate, as well as the firms profit are analytically
derived. We find that the borrowing rate is an increasing function of the firms capacity level.
Thus, there must be a trade-off between the potential benefit of expanding the capacity with
borrowed money and the burden of possibly hiking risk premium charged in the borrowing rate.
The firm may optimally choose a capacity that protects the interest of the lender by reducing the
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expected losses in bankruptcy. But this is usually done with a distortion of the optimal capacity
investment, which in turn gives rise to the agency cost. The agency cost is rather significant;
indeed, it can arise even when the firm has perfectly eliminated the possibility of bankruptcy (or
it is just the expense of eliminating the possible bankruptcy). We further corroborate these results
by extending the discussion to a generalized setting, with the assistance of a numerical study.
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The numerical results support our analytical insights. In all, our results highlight the complex
relationship among capacity decisions, debt financing, and agency issues for small firms, as
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indicated by many practical evidences (see, e.g., Graham 2003, Van Mieghem 2003).
Related literature
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This paper belongs to the growing literature on the interface of operations management and
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finance. Conventional studies in operations management assume that the firm can make
operational decisions without considering the financial aspect of the firm, i.e., the separation of
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the operations and financial decisions (Xu and Birge 2004). Such a separation is often based on
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the Modigliani-Miller theorem (Modigliani and Miller 1958), which is valid in a frictionless
market that does not involve any taxes, bankruptcy costs, agency costs, and asymmetric
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information. In practice, however, the marketplace always has some frictions. Therefore, it is
necessary to investigate the interactions between operations and finance (Birge 2014).
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In the past few years, there are quite a few papers investigating the interactions between
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operations management and financial hedging. These papers typically consider the joint
operational and financial hedging decisions of a risk averse firm. To describe the risk aversion, a
specific utility function is then adopted to formulate the objective function. For example, Gaur
and Seshadri (2005) studied a newsvendor-type firm who uses financial hedging to maximize a
mean-variance utility function. Caldentey and Haugh (2006) proposed an approach to jointly
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optimize the operations and financial hedging policy under the mean-variance framework. Ding
et al. (2007) similarly adopted a mean-variance utility as objective function to investigate the
implication of financial hedging on a global firms operations. Later, Chod et al. (2010)
flexibility and financial hedging opportunity. Using a similar exponential utility, Ni et al. (2016)
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then revealed that there can be a weak separation between the operations decision and financial
hedging strategy of a firm. Other related studies can be found in Van Mieghem (2003), Chen et
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al. (2007), Ni et al. (2012), Kouvelis et al. (2012), Okyay et al. (2014), Sayin et al. (2014), and
Zhao and Huchzermeier (2015). The rationale for hedging in a risk-neutral setting has also begun
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to gain attention in the operations management literature. In a budget constrained risk-neutral
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supply chain, Caldentey and Haugh (2009) showed that financial hedging can be employed to
mitigate the effects of the financial constraint so that the output can be boosted. Turcic et al.
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(2015) explored when and how financial hedging can be utilized to avoid possible costly
breakdown of a risk-neutral supply chain. Our paper contributes to the literature by exploring the
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role of financial hedging in reducing the agency cost in a risk-neutral setting. In addition,
different from this paper, the aforementioned studies focused on settings in the absence of debt
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financing.
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strategy. Actually, several recent papers have begun to investigate the possible interactions
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between operational decision and debt financing (e.g., Buzacott and Zhang 2004, Dada and Hu
2008). In general, the debt or borrowing may arise in a variety of forms, such as getting a loan
from a commercial bank (e.g., Lai et al. 2009, Kouvelis and Zhao 2011), acquiring trade credit
from suppliers (e.g., Troutt and Acar 2003, Seifert et al. 2013), or even obtaining credit from
3PL firms (Chen and Cai 2011). Here, it is worth noting that the use of debt financing in
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coordinating the supply chain has received much attention nowadays, perhaps since Dada and Hu
(2008). Typical papers in this vein include Kouvelis and Zhao (2011), Jing et al. (2012), Jing and
Seidmann (2014), and Cai et al. (2014). An important feature of these papers is the comparison
between two important debt-financing channels: loan offered by banks and trade credit offered
by suppliers, with an emphasis on the effects of bankruptcy costs. It is shown that the bankruptcy
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cost can have complex effects on the supply chain, especially when there are several downstream
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Recently, several papers have investigated the impacts of external debt financing on a firms
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choice on dedicated vs. flexible technology in capacity investment. Boyabatli and Toktay (2011)
analyzed the impact of endogenous credit terms under capital market imperfections on the
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capacity investment choice of a financial constrained firm. In their model, it is assumed that the
debt holder firstly offers the loan contracts, and the firm makes its investment choice afterwards.
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Their results demonstrate that the endogenous nature of credit terms may change the conclusions
about optimal capacity investment choice obtained under the perfect market assumption.
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Boyabatli et al. (2016) then investigated how the tightening of the capital budget and a lower
financial flexibility, which is measured by the likelihood of having sufficient operating budget in
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Agency problem arising from external financing has been extensively studied in the
economics and finance literature. For instance, Mello et al. (1995) investigated the agency
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problem incurred by the distortion of the choice of the critical exchange rates to switch the
sourcing of its production between countries. They showed that financial hedging can be applied
to mitigate the agency cost. We confirm their finding that financial hedging is an effective
manner in reducing agency cost while in a different operational context. Although the operations
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management literature has recognized the importance of external financing in helping firms
maintain healthy financial status, little attention has been paid to the agency cost incurred due to
the debt financing. An important paper that firstly addresses the agency problem in a capacity
investment in the presence of debt financing setting is Chod and Zhou (2014). Although the
agency conflict between the equity and debt holders is also a main feature of our paper, there are
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several key differences. Chod and Zhou (2014) assumed that the expected cost of financial
distress, which is parallel to the bankruptcy cost, is proportional to the shortfall between the debt
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obligation and the firms asset value. Besides, they concentrated on analyzing the optimal
investment in the capacity of flexible and nonflexible resources. Their results suggest that
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resource flexibility mitigates the downside risk as well as the agency conflict between the equity
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and debt holders. In contrast, we assume that the bankruptcy cost is proportional to the
liquidation value of the firm, which is consistent with the finance literature (e.g., Mella-Barral
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and Perraudin 1997, Broadie et al. 2007). Accordingly, we focus on analyzing the firms decision
making related to capacity investment under external debt financing. We highlight the
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significance of agency problem besides the threat of bankruptcy, which will play a crucial role in
the firms capacity decision making. We find that in some cases, the agency cost can exist even
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when the expected bankruptcy cost is eliminated. We then show that when the selling price of
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the firms product is significantly correlated with a market index, the firm can deploy a financial
hedging scheme to effectively control the agency problem. Moreover, the influence of corporate
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tax is also examined. We show that as the tax rate increases, the agency cost will decrease while
both the optimal capacity level and the borrowing rate will increase. Although Gamba and
Triantis (2014) also analyzed the effects of tax rate in the interaction between operations
management and finance, they ignored the agency problem, which is the key feature of this paper.
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The remainder of this paper proceeds as follows. In section 2, we firstly model the capacity
investment with debt financing. Then, the optimal policy of the firm is analytically discussed. In
experiments are conducted to corroborate the analytical results and derive some managerial
insights. In section 4, we present some concluding comments and suggest some future research
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directions. All proofs are presented in the Online Appendix.
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2. Capacity decision with debt financing
In this section, we firstly describe the basic framework of capacity decision-making problem
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with debt financing. Then, we introduce the agency problem in debt financing, i.e., the possible
conflicts of interest between the debt and equity holders of the firm. Several analytical results are
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derived and discussed. The basic trade-offs behind the firms optimal capacity choice are shown.
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Consider a firm who needs to invest in capacity (e.g., various resources and equipment) in
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advance for production, and then sells its final products to the market at an uncertain clearing
price (that is, the price at which the market will clear in the sense that all products are sold; see
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Caldentey and Haugh 2009). Let be the amount of the capacity invested at time 0. Then the
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firm will have units of product to sell at time 1. However, when making the capacity decision
at time 0, the firm is uncertain about the market clearing price of the product. Following
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Caldentey and Haugh (2009), given the capacity , the market clearing price is , where
is a random factor that models the market size while is a constant that captures the
(negative) price elasticity of demand. Then, for any given capacity level , the sales revenue
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{ (1)
is the probability of having a poor market prospect ( ). This assumption will be relaxed in
section 3.
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To finance the capacity investment at time 0, a potential difficulty is that the firm may only
have limited internal capital, and thus would become capital-constrained in making the
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investment. To raise sufficient fund, the firm may need to borrow some money from outside
lenders such as commercial banks, which is also referred to as debt holders in this paper.
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Sometimes the firm could obtain trade credit from its supplier, and in this case one may also
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perceive the supplier as a debt holder who provides a loan to the firm. Apart from debt financing,
in some cases a firm might also raise additional equity capital by issuing new equity when
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running out of cash. For simplicity, we assume that such issuance of new equity is not allowed.
This assumption is not unrealistic because it is consistent with the pecking order theory in
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corporate finance, which states that firms should prioritize different sources of financing, firstly
preferring internal funding, and then debt, lastly issuing new equity as last resort (Brealey et al.
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2008). Further, it allows us to avoid modeling the dynamic capital structure of the firm, which is
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too complicated to cover in the proposed model (see, e.g., Leland (1998) for a model of the
dynamic capital structure). In addition, we also assume that the debt financing takes a simple
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structure and there is no collateral for the loan (Dada and Hu 2008, Jing et al., 2012, Jing and
Seidmann, 2014). Despite such simplifications on the financing choices, as will be shown, our
study can reveal several essential trade-offs behind the firms optimal decisions on capacity, debt
financing.
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distinguish between debt holders, who provide loans, and equity holders, who own the firm. We
assume that the firm should choose its policy to optimize the firm earning for equity holders
(perhaps after paying corporate tax). This amounts to requiring that managers of the firm act in
the interests of equity holders. We note that in reality, there would be conflicts of interest
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between managers and equity holders, which may arouse the well-known principal-agent
problem and cause the agent (manager) to violate the best interest of the principal (equity holder).
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However, this problem could be resolved by designing an incentive-compatible employment
contract for managers; see Bolton and Dewatripont (2005) for a detailed discussion. As a result,
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we can simply treat the firms policy as determined by the equity holders of the firm whereas the
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borrowing rate being determined by debt holders.
2.2. Decision-making under conflicts of interests between equity and debt holders
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As well-documented in the financial economics literature (see, e.g., Froot et al. 1993, Leland
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1998, Brealey et al. 2008), a key issue pertaining to the debt financing scheme is that the
potential conflicts of interest between equity and debt holders. However, it is still unknown
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whether and how such conflicts should arise in our capacity planning problem, which is the focal
To proceed, the borrowing rate of the debt is firstly discussed. Let be the unit investment
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cost of the capacity at time 0. So the investment is financed by a debt that amounts to . The
debt will be repaid at time 1 with amount , where is the borrowing rate. Because the
investment is risky ( is uncertain), the debt holder may ask for a higher borrowing rate for
bearing the risk. Let be the risk-free borrowing rate (Duffie 2001). As will be shown, we
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How much risk premium the debt holder should charge depends on how much risk the debt
holder is bearing. However, in our case the risk pertaining to the debt borrowing is complicated:
it will arise not only from the uncertain market prospect of product, but also from a so-called
agency problem, that is, it is not necessary for the firm to act in the interest of the debt holder.
Although the equity holder should also gain a profit only when the debt obligation can be
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fulfilled, he just has limited liability to pay back the debt, and the firms goal is to optimize the
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equity holders value. To analyze the firms optimal choice, it is necessary to define the debt-free
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profit that quantifies how much the equity holder can gain:
rate is exogenously determined, to maximize the equity holders value the firm will make the
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[ ] (3)
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which is subject to (2). As can be seen in expression (3), the debt holders interest is not
explicitly considered.
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So the debt holder would protect themselves by charging a high borrowing rate, addressing the
concern that her interest might be undermined as the firm aims to maximize the equity holders
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profit. To analyze such an issue, the borrowing rate charged by the debt holder must be
endogenized, and this is done by resorting to the well-known costly state verification (CSV)
approach (see, e.g., Townsend 1979, Gale and Hellwig 1985, Bolton and Dewatripont 2005).
Formally, let be the (proportional) bankruptcy cost, which can be understood as the
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transaction costs incurred in the liquidation of the firms assets in case of default (Tirole 2006, p.
143). We assume that the financial market is perfectly competitive, such that the debt holders
expected cost equals her expected revenue. We note that this assumption is widely applied in the
literature on the operations-finance interface, such as Kouvelis and Zhao (2012), Jing et al.
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Then, the CSV approach determines the required borrowing rate as follows:
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[ ] [ ( )] (4)
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On the left side of equation (4), the first term is the expected value of the debt payment if the
debt holder receives in full, while the second term captures the expected value of the
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debt service if the debt obligation is not fulfilled. Thus, the sum of these two terms is the
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expected revenue of the debt holder, which should equal the expected cost in a
For the sake of clarity, three comments on the CSV approach are in order.
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(i) When Townsend (1979) firstly introduced the original version of the CSV approach, he made
the assumption that the firms cash flows are observable to the firm owner, but can only be
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observed by the external creditor (debt holder) only at some cost. Then, Townsend (1979) and
Gale and Hellwig (1985) have shown that the optimal contract between external creditor and the
firm will be a standard debt contract, and the costly verification of the cash flows will only be
carried out in case of default. However, subsequent studies usually choose to interpret the CSV
model in terms of Chapter 7 bankruptcy, which appears more natural in practice (e.g., Leland
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1998, Kouvelis and Zhao 2011). Whatever interpretation to choose, the modeling insights should
carry over.
(ii) The bankruptcy cost in this paper can be interpreted as the transaction costs in the
liquidation of the firms assets, which is related to Chapter 7 bankruptcy (Broadie et al. 2007).
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This bankruptcy cost is assumed to be proportional to the liquidation value of the firm, which is
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consistent with many studies in the finance literature (e.g., Leland 1998, Broadie et al. 2007).
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(iii) For tractability, we do not consider the possible strategic debt service (Mella-Barral and
Perraudin 1997) in debt financing, which is important when the firm can seek for reorganization
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(Chapter 11) at financial distress. Strategic debt service indicates the strategic behaviors of the
equity holder against the debt holder at financial distress, given that the terms of the debt can be
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renegotiated between the equity and debt holders at reorganization. As suggested by Mella-
Barral and Perraudin (1997), the existence of the strategic debt service may substantially increase
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the borrowing rate required by debt holder. Due to the high complexity in tackling the issue of
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strategic debt service between equity and debt holders at financial distress, we focus on the
Chapter 7 bankruptcy for tractability. However, the effects of strategic debt service at
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We next consider the tax benefit associated with debt financing in the capacity investment
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problem. According to Graham (2003), the tax benefit of debt can arise if the interest payment of
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the debt is deductible from the taxable income. As a result, given a tax rate , the amount of tax
payable should be calculated as , where the first term is the tax payable if there is no
debt interest payment at time 1, and the second term is the tax benefit of the debt as in
Leland (1998). Note that in this tax formulation we ignores the complication of accounting for a
negative operating profit, which may lead to a zero taxable income, and this simplification can
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be regarded as a reasonable approximation of the realistic tax scheme that will not distort our
main results. Accordingly, after accounting for the corporate tax, the capacity decision problem
then is to find the best capacity level that solves the following model:
[( ) ] (5)
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which is subject to (2) and (4). Note that the only difference between the optimization problem
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(5) and problem (3) is the additional constraint (4), which addresses the debt holders concern
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using the CSV approach.
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It is worthwhile to explain the necessity of jointly considering the investment and financing
decisions in the above model. In fact, an influential paper of Modigliani and Miller (1958) has
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suggested that firms in a frictionless market can readily consider their investment and
financing decisions in a separate manner. However, several important market frictions, such as
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the agency problem we introduce, should come into play in the capacity investment problem
with debt financing. This study therefore deviates significantly from the conventional
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It is, of course, more difficult to analyze the problem (5) with the constraint (4) due to the
partially alleviate the difficulty by focusing on the case of binary uncertainty in market size, as
specified in expression (1). The first step is to investigate how the borrowing rate charged by the
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Proposition 1 then shows that the unique borrowing rate that satisfies the constraint (4) can
Proposition 1. Given a fixed capacity level , the borrowing rate that the debt holder
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will charge is uniquely determined as follows:
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{
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Three important observations follow from Proposition 1. First, the borrowing rate is a
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non-decreasing function of . Second, if the product is highly profitable, i.e.,
, then there is no need for the debt holder to worry about the money borrowed and so the
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, then the debt holder does need to worry about the money borrowed and charges a high
borrowing rate that depends on both , the chance of having a good market prospect, and , the
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bankruptcy cost rate. Besides, the effect of tax rate on the borrowing rate cannot be shown
implicitly. Instead, the effect can be observed through its effect on the capacity choice.
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The result that is an increasing function of appears to be inconsistent with the theory
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of Modigliani and Miller (1958), which suggests that investment decisions should be
and Meckling (1976), which argues that equity holders of a levered firm can potentially extract
value from debt holders by increasing investment risk after debt is in place (i.e., the so-called
asset substitution problem). In fact, our result is consistent with the analysis of Leland (1998),
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which develops a unified framework that encompasses elements of both the Modigliani-Miller
and Jensen-Meckling theories. According to Leland (1998), the yield spread on debt has a
positive relationship with the firms leverage ratio due to the agency cost. In this paper, a higher
capacity investment means a larger size of debt financing, which is also associated with a
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Next, to solve for the optimal capacity decision of the firm, one may substitute into
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expression (2) and maximize the objective function (5). However, it turns out that the solution is
extremely complicated. Therefore, to simplify the analytical solution, we focus on the limit case
than the tax rate as in Leland 1998). Even under such a limit case, we find that the agency
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problem will arise if market uncertainty is high, with the bankruptcy cost and tax rate
playing important roles. Later, we will complement the analytical study with numerical results.
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Because the derivation of the analytical solution is rather complicated, it is presented in the
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Proposition 2. (i) The optimal capacity of the firm takes value from the four possible values
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, where , ,
, and .
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(ii) Under the optimal capacity, there are three possible values of the borrowing rate, namely,
the optimal capacity is ( ), the borrowing rate is . When the optimal capacity
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rate is . Further, the upper bound of the borrowing rate is , that is, the following
inequality holds .
(iii) Let , , , and be the firms profit under the capacity level , , , and ,
respectively. Then, the conditions under which the firm will optimally choose the capacity level
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( ) and earn the profit depend on the parameter values such as the
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bankruptcy cost rate , the unit cost of capacity, as well as the probability of having a good
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market prospect. Because these conditions are lengthy and complex, we summarize them in
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Interpretation and discussion
The results shown in Proposition 2 deserve some discussion. Recall that there should be conflicts
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of interest between the debt and equity holders in the capacity decision-making of the firm. Thus,
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the main purpose of the discussion here is to show that the conflicts of interest could shape the
firms optimal policy in a variety of ways. The detailed discussion is presented below.
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Suppose that (see Table 1 in the Appendix; the alternative situations where
case that the chance of having a good market prospect ( ) is lower than the threshold ,
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i.e., . Under this case, there is no conflict of interest between debt and equity holders. To
see this, notice that the optimal capacity level now is , which is
exactly the solution that maximizes the joint income of both the debt and equity holders:
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achieves the first-best result from an economic perspective (see, e.g., Gale and Hellwig 1985,
Bolton and Dewatripont 2005). So there is no agency cost arising from conflicts of interest for
this case.
Second, consider the case that the chance of having a good market prospect is between the
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two thresholds and , i.e., . In this case, there is the conflicts of interest
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between equity and debt holders. Specifically, the firm is so worried about the potential loss of
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bankruptcy that the most conservative capacity decision is made to prevent it. Thus, it is optimal
to choose the most conservative capacity level , where the good market prospect
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is just ignored in the expression. This guarantee that bankruptcy will never happen. As a result,
bankruptcy is no longer a concern for the debt holder, but the downside is that the firm should
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choose a capacity departing from the first-best level . Such a distortion in capacity
investment will take a toll, even though the potential loss of bankruptcy is reduced to zero. That
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is, there is an agency cost arising from the conflicts of interest, i.e., the equity holders profit falls
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.
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Next, consider the case that the chance of having a good market prospect is between the two
thresholds and , i.e., . Then, the conflicts of interest between equity and debt
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holders can affect the firms optimal policy in two different ways. The first scenario ( )
is just analogous to the case of . The second scenario is that the bankruptcy cost is
sufficiently low such that . In this scenario, the firm may go bankrupt. So the debt
holder should worry about whether the firm can finally pay back the borrowed money. As a
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compensation for bearing the credit risk, a relatively high borrowing rate is charged:
from the first-best level . Such a distortion can also give rise to an agency cost:
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.
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Last, consider the case that the chance of having a good market prospect is higher than the
threshold , i.e., . In this case, the conflicts of interest between equity and debt holders
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can also affect the firms optimal policy in two different ways. The first scenario (
market prospect is also not incorporated. However, there is the possibility of bankruptcy of the
firm, and the borrowing rate is higher than the risk-free interest rate .
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To summarize, the conflicts of interest between debt and equity holders may arise in different
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forms. In the decision-making process of the capacity investment, firm may or may not try to
protect the debt holders interest, depending on the uncertainty of the market prospect and the
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size of the potential bankruptcy cost. Either way, there should be the agency cost, as the firm
While the study presented in the former section provides an understanding on how the agency
problem the conflicts of interest between debt and equity holders should affect the capacity
investment of the firm with debt financing, the analytical results is obtained under a stringent
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assumption, that is, the market prospect of product can only be good or bad. In reality, however,
there should be other intermediary possible states of the market prospect. Therefore, the
In particular, we expand the analysis to the cases in which the uncertain market prospect
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follows more generalized distributions. Let and be the respective probability density
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function and cumulative distribution function of the random variable . As introduced by Froot
[ ] is
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et al. (1993), it is necessary to require that the hazard function
increasing in , so as to ensure that the borrowing rate can be appropriately determined by the
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CSV approach. However, this is a fairly common condition satisfied by the commonly-used
We start by briefing the generalized model before presenting the analytical results. The firm
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needs to make the capacity investment with debt financing, but the debt holder may ask for a
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high borrowing rate for bearing the credit risk, which is modeled through the CSV approach (4).
The credit risk could arise since the market prospect of the product is uncertain, which is
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intuition about the underlying trade-off is that the bigger the risky investment, the higher the
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borrowing rate. Thus, the firm should optimally choose a capacity level that maximizes the
equity holders profit, i.e., optimizing the objective function (5), given that the operating
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The complication of the generalized model lies primarily in the difficulty to solve for the
borrowing rate from equation (4). It is in general impossible to obtain an analytical expression
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for in parallel with Proposition 1. Instead, some analytical properties are derived and presented
below.
First of all, to investigate the structural properties of the equation (4), let us introduce an
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[ ] [ ( )]
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Then, the left-hand side of equation (4) can be expressed as . Clearly,
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when .
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]. We point out that there exists a unique stationary point of , that is,
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. Indeed, because , is equivalent to
We can characterize the required borrowing rate with the assistance of , as stated in
Proposition 3. Through this proposition, we verify the intuition that the borrowing rate is an
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Proposition 3. (i) Suppose that the capacity level chosen by the firm is [
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(ii) Once is obtained, then the borrowing rate as a function of the chosen capacity
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. In other words, the borrowing rate will increase more and more rapidly as the chosen capacity
level rises, suggesting that the firm really needs to contemplate the burden of borrowing cost
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when attempting to borrow more money to expand the capacity. Indeed, one may re-write the
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debt-free profit as . Its second-order derivative is strictly
( ) ( )
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negative: following Proposition 3(ii).
The convexity of
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also suggests a major trade-off between the benefit of capacity
investment and the potential cost burden of debt financing: while the firm would benefit from
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investing more in capacity, the larger amount of money required to fund the investment may
incur a higher borrowing rate if the firm is capital-constrained. Such a trade-off highlights the
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conflicts of interest between the equity and debt holders of the firm. Sometimes, the equity
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holder may prefer to have more risk while the debt holder may not. To illustrate, the concept of
mean-preserving spread is borrowed from the finance literature (Ingersoll 1989), so we can
formally define the idea of more risk. Specifically, a random variable is said to be a mean-
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preserving spread of another random variable if and only if there exists a third random
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variable , which has zero mean ( [ ] ) and is independent of , such that has the
same distribution as (see Ingersoll 1989 for a technical discussion). In our context, this can be
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alternatively interpreted as under capacity decision having more risk than with capacity
. Then, all else being equal, the expected profit for the equity holder will be higher if there is
more risk. In other words, there might be an incentive for the equity holder to deliberately take
23
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Lemma 1 may also be understood as follows: equity holders could gain a positive income only
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if the realized operating revenue is higher than the specified debt payment, which means that the
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equity holders in effect hold call-type options of the firms operating revenue (Leland 1998). As
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is standard in the real options literature, we know that the value of a call option will be larger for
a higher uncertainty (Duffie 2001); thus, equity holders might prefer to have a higher profit
approach (see equation (4)), debt holders can get at most no matter how high is; in
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other words, they cannot share value with equity holders if the realized operating revenue is high,
but would still be exposed to substantially losses if the realized operating revenue is very low. As
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a result, there is the concern that equity holders may benefit themselves by taking risky
investment at the expense of debt holders (Leland 1998). To prevent the potential risk-seeking
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behaviors of equity holders, the debt holders would ask for a higher borrowing rate if the loan is
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riskier, as suggested by Proposition 3(ii). The equity holder must realize that any risk-taking
behavior of the firm would result in a high borrowing rate, and incorporate the debt holders
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As discussed above, debt holders are more willing to lend money to firms with less uncertainty.
Thus, the firm may reduce its profit uncertainty by financial hedging, so as to enhance the firms
24
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debt capacity. We capture the possible hedging opportunity by assuming that the uncertain
market clearing price of the firms product is significantly correlated with the random price of a
financial security. In practice, such a security may refer to either a market index such as S&P
500 (Gaur and Seshadri 2005), or an exotic derivative such as weather derivatives (Chod et al.
2010). While realistic hedging opportunity may arise in various forms (e.g., using a portfolio of
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futures, options, and/or swaps), this setting allows us to better understand what role financial
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Let be the security price at time ( ), and the correlation coefficient between the
( )
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random price factor and . Then, the standard minimum-variance hedge ratio is
Chod et al. 2010), the financial market is assumed to be arbitrage-free, that is, [ ] . The
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Despite the potential benefits, financial hedging would be costly in practice, especially for
those exotic derivatives (e.g., weather derivatives, see Chod et al. 2010). For simplicity, we
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summarize the possible cost of financial hedging by a (proportional) cost term . For an
derivative, should then be understood as the price premium that a financial institution (e.g.,
an investment bank) would charge for providing such a derivative. Note that the cost of financial
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of the hedging position per unit capacity is ( ) | |, and the debt-free profit with
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(6)
problem then is to maximize the objective function (5) under the constraint (4), with being
replaced by .
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Due to the high complexity, the generalized model (with or without hedging) cannot be solved
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in an analytical way as in section 2. To further investigate how the potential conflicts of interest
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between debt and equity holders will affect the firms optimal policy, as well as estimating the
agency cost that follows, we resort to numerical means. The numerical experiments will be
In this section, numerical experiments are conducted to examine the optimal capacity choice, the
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borrowing rate, the equity holders profit, as well as the agency cost in the capacity investment of
a firm using debt financing, given that there is financial hedging. Note that the no-hedging
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situation is just a special case of zero correlation (i.e., , which leads to ). The purpose
is to show how the conflict of interest between debt and equity holders, the tax benefit of debt
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financing, and the deployment of financial hedging will shape the optimal decision of the firm.
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To evaluate the agency cost arising from conflicts of interest between the debt and equity
holders, we firstly describe the idea of the first-best benchmark regarding the firms capacity
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investment (an analytical discussion of the first-best benchmark for the simplified case is given
in section 2.3, just after Proposition 2). If there is no agency problem between debt and equity
holders, the optimal capacity choice should maximize the joint income of both the debt and
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at . The first-best and is the ideal capacity level and profit of the firm if
the interest of the equity holder coincides perfectly with that of the debt holder. If not, there
should be losses (i.e., agency cost) due to conflicts of interest. Thus, the agency cost can be
shown via examining by how much the actual profit falls short of the first-best .
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We now set the base-case values of model parameters. Without loss of generality, the unit cost
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of capacity is normalized as . For simplicity, the random price factor is normally
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distributed, with a mean and a volatility (standard deviation) . Because the average market
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moderate 20% gross profit margin in the subsequent numerical study. To emphasize the market
uncertainty, we then set . The risk-free rate is , the tax rate is set at , and
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the bankruptcy cost rate is set at .
We solve for the firms optimal policy using the stochastic programming approach (Birge and
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discretization, and then converting the original stochastic optimization problem (5) as well as the
constraints into their deterministic equivalent problems; these deterministic problems can then be
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solved by conventional deterministic algorithms; see Birge and Louveaux (2011) for a detailed
description of this stochastic programming approach. With this approach, we conduct the
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sensitivity analysis for a wide range of parameter values. The results are quite robust, and so we
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Market uncertainty
We start by investigating the capacity decision , the borrowing rate , the expected profit , as
well as the agency cost under different levels of market uncertainty . The results of the
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Figure 1: Sensitivity analysis on degree of uncertainty
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We firstly look at panel (a) in Figure 1. We observe that the optimal capacity (solid line)
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under the agency problem remains lower than the first-best (dashed line) when the market
uncertainty is positive. Moreover, as market uncertainty increases, the optimal capacity level
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decreases fast. A simple explanation of the observation is that the borrowing rate will increase
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with the market uncertainty, as shown in panel (b), and this drives the firm to shrink its capacity
level to reduce the risk and control the borrowing rate. However, as we discussed in section 2.3,
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the essential reason actually lies in the agency problem of debt financing the debt holder has to
protect her own interest that may not be protected appropriately by the firm.
The effect of the agency problem can be seen clearer in panel (c), where the upper dashed line
is the ideal first-best profit while the lower solid line is the actual profit under the agency
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ACCEPTED MANUSCRIPT
issue. We observe that agency problem drives the firms profit down from the first-best level
very quickly as the market uncertainty increases. This observation also suggests that managers
can alleviate the agency problem and increase the firm value by effectively controlling the
market risk .
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It is worth noting that apart from the agency issue, there is still the threat of potential
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bankruptcy that may play a role. Thus, a natural question arises regarding whether the low profit
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( ) is due to the potential bankruptcy cost. In fact, from the expression (4) of the CSV
line in panel (c). As can be seen, the relative size of the bankruptcy cost is rather small. The
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dotted line remains still substantially lower than the first-best benchmark (the dashed line); and
the difference is taken as the agency cost, which we plot in panel (d). These observations imply
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that it is the agency cost, rather than the bankruptcy cost, that drives the firm to refrain from
taking a high capacity level that may have high risk. This finding is consistent with the analytical
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Bankruptcy cost
Next, we explore how bankruptcy cost will affect the conflicts of interest between the debt and
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equity holders. This will in turn impact the borrowing rate required by the debt holder, the firms
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optimal policy, the agency cost, and its profitability. Figure 2 depicts the results.
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Figure 2: Sensitivity analysis on bankruptcy cost rate
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From panel (a) of Figure 2, we observe that as the bankruptcy cost rate increases, the
optimal capacity level (solid line) under the agency issue will decrease, but just at a relatively
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moderate speed as compared to the effect of market uncertainty in panel (a) of Figure 1. Similar
observation holds for the borrowing rate shown in panel (b). These observations imply that the
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negative impact of potential bankruptcy is effectively controlled in making the capacity decision
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Besides, panel (c) further confirms that the agency cost should dominate the bankruptcy cost,
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as the dotted line (actual profit plus expected bankruptcy cost) is just slightly higher than the
solid line (the actual profit), and remains substantially lower than the dashed line (the first-best
profit). Nevertheless, as shown in panel (d), the agency cost still will increase as the bankruptcy
cost rate increases. The results suggest that while the direct effect of the bankruptcy cost on
capacity decision is just moderate, the bankruptcy cost can still indirectly affect the firms policy
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by magnifying the agency issue, i.e., the conflicts of interest between debt and equity holders of
the firm.
Corporate tax
The third sensitivity analysis is to explore how tax rate should play a role in the firms capacity
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decision with debt financing. Although it is known that there is a tax benefit of debt financing, it
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is still not clear how the firm should act optimally with this tax benefit. The results are charted in
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Figure 3.
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AN
M
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Figure 3 shows that while both the optimal capacity and the borrowing rate are increasing
with the tax rate , the firms expected profit is a decreasing function of . With the increase of
the tax rate, the tax liability of the firm will increase while the agency cost will decrease. In other
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words, the potential agency conflict between the equity and debt holders is less intense for a
higher tax rate. Besides, it appears that the expected bankruptcy cost is almost unchanged as the
tax rate changes. All these three factors (i.e., tax liability, agency cost, expected bankruptcy cost)
can erode the expected profit for the equity holder. However, after summing up the effects of all
the three factors, the net result is still that the firms profit will decrease with the tax rate.
T
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Moreover, the optimal capacity level is higher for a higher tax rate, which might be due to the
equity holders effort to increase profit. This is consistent with our analytical results (from Table
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1, one can verify that , ,
, and
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). To build up a higher capacity, however, the firm needs to borrow
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more debt at a higher borrowing rate (from Table 1, we know that ,
[ ]
).
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Financial hedging
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Now, we turn to analyze how the optimal capacity decision of the firm will be affected by
financial hedging opportunities. Therefore, we plot the capacity decision, the borrowing rate, the
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firms profit, as well as the agency cost as functions of the correlation ; see Figure 4. The
proportional transaction cost of the financial security used for hedging is set at .
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AC
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Figure 4: Sensitivity analysis on correlation
AN
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From Figure 4, we observe that as the absolute value of the correlation increase, the optimal
capacity as well as the firms profit will increase whereas the borrowing rate will decrease.
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This observation confirms the effectiveness of financial hedging. As shown in panels (c) and (d),
both the agency cost and the expected bankruptcy cost are lower with the deployment of
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financial hedging, which implies that hedging can mitigate the agency conflict in debt financing.
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Thus, the borrowing rate required by the debt holder is lower. The higher the absolute value of
investigate the impacts of the transaction cost for the financial security in the hedging
opportunity. Given the transaction cost, we compare the performances of a firm with financial
hedging (solid line) against a firm without hedging (dotted line). In this numerical study, the
correlation is set at (Gaur and Seshadri 2005). The results are shown in Figure 5.
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Figure 5: Sensitivity analysis on transaction cost rate
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We can see from Figure 5 that an increase of transaction cost rate can decrease both the
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optimal capacity and the firms profit with financial hedging (solid line). This is expected
from intuition. As increases, financial hedging will become more costly. Besides, a higher
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will also lead to a bigger agency cost and a higher borrowing rate, which in turn depresses the
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capacity investment.
However, Figure 5 also shows that even with a significant transaction cost , a firm with
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financial hedging (solid line) can still outperform a firm without financial hedging (dotted line).
In panels (b) and (d), the solid lines remain significantly lower than the dotted lines even for
, implying that financial hedging can still effectively mitigate the agency conflicts
between the equity and debt holders and reduce the borrowing cost. In panels (a) and (c), the
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solid lines are significantly higher than the dotted lines, suggesting that both the optimal capacity
and the firms profit are higher under financial hedging than the no-hedging case. We note that
the interval [ ] is already sufficient to cover the possible transaction cost in financial
hedging. In fact, the transaction cost rates for exchange-traded equity index futures in practice
are usually lower than 0.001. Hence, that is already an extremely large value for the
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transaction cost rate in financial hedging.
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Finally, we note that although intuitively a firm borrowing more money should be subject to a
higher borrowing rate, which in turn erode the firms profit (see Figure 3), this intuition may not
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always hold true. Indeed, figures 4-5 shows that the firm borrowing more money may be subject
to a lower borrowing rate if it can employ financial hedging to effectively reduce the risk. These
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results, therefore, suggest that the borrowing rate as well as the firms profit are not necessarily
monotonic functions of the debt size. This is consistent with the analysis of Leland (1998), which
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also shows that the borrowing rate and firm value are not monotonic functions of the leverage
ratio.
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4. Concluding remarks
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In this paper, the capacity decision with debt financing is studied with due consideration of the
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agency problem. We have analyzed how the optimal capacity decision is affected by the
potential conflicts of interest between debt and equity holders, which can result in an agency cost.
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It is shown that the agency cost can be rather significant in capacity expansion. In contrast, the
expected bankruptcy cost for the debt holder may not be very significant. In some extreme cases,
the agency cost can still exist even when the expected bankruptcy cost is eliminated. Besides, the
corporate tax also plays a role. In fact, the numerical study of Chod and Zhou (2014) finds that
the firm tends to borrow more when the tax rate is higher. Our study confirms their finding with
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both numerical and analytical results. Then, in addition to the finding of Chod and Zhou (2014),
our analysis further shows that the firm will optimally choose a higher capacity level under a
higher tax rate, thus reducing the agency cost. Moreover, we also find that lenders will tend to
ask for a higher borrowing rate when the tax rate is higher, an unfavorable consequence that can
erode the tax benefit associated with debt financing. An interesting implication of these results is
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that the impacts of changes in corporate tax rate under the agency conflicts should be more
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Next, we show that the agency cost can be controlled by financial hedging, and the
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effectiveness of hedging relies on the correlation between the stochastic price of the financial
security used for hedging and the random price factor of the product. Although this result does
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not appear to be new (Gaur and Seshadri 2005), our analysis helps improve our understanding of
the efficacy of financial hedging. In fact, existing studies on the joint operations and financial
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hedging decisions usually assume that the firms objective is to optimize an increasingly concave
utility function (e.g., Gaur and Seshadri 2005, Chod et al. 2010); but in practice, it might be
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difficult to explain the elusive meaning of a utility function to managers. Alternatively, our
analysis initiates the motivation for financial hedging from the firms potential needs to enhance
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its debt capacity for financing the capacity investment, which would be more natural from a
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practical perspective. Without using a utility function, our result that financial hedging should be
valuable can also be contrasted with the result of Gamba and Triantis (2014), which suggests that
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the value of financial hedging is likely to be low. Although Gamba and Triantis (2014)
considered both the personal and corporate taxes as well as the convexity in tax rates, they did
not consider the agency problem. Thus, the deviation between the result of Gamba and Triantis
(2014) and our result highlights the importance of the agency problem in assessing the value of
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financial hedging. Our point is also supported by empirical studies such as Campello et al. (2011)
In addition, our study shows that the firm can resort to financial hedging to reduce agency cost
even under a significant transaction cost of hedging. Given the significance of agency cost, our
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results can provide a new rationale to understand the complementary/substitutable relationship
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between financial hedging and operational flexibility (Chod et al. 2010). If the operational
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flexibility aggravates the agency problem, it would boost the need for financial hedging to
mitigate the agency cost; thus, one would expect a complementary relationship between the
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operational flexibility and financial hedging. This happens for the case of product flexibility
when product demands are positively correlated (Chod et al. 2010). In this case, the firm will
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tend to utilize the product flexibility to increase its operating profit variance, which is clearly
unfavorable for debt holders in our context. Accordingly, the agency conflict between the firm
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owner and the debt holder will be aggravated with the product flexibility; so the product
flexibility and financial hedging tend to be complements in this case. Instead, if the operational
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flexibility mitigates the agency problem, then one would expect that the operational flexibility
and financial hedging tend to be substitutes. This happens for the case of product flexibility when
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product demands are negatively correlated, because the firm will tend to utilize the product
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flexibility to reduce its operating profit variance in this case. Note that Chod et al. (2010)
essentially assumed an exponential utility function in their study. Hence, we hope that the above
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discussion on agency cost can help advance our understanding on the relationship between
Our analysis yields several managerial implications for a financially constrained firm to
improve its capacity management through debt financing. First, while the firm can use debt
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ACCEPTED MANUSCRIPT
financing to relax the financial constraint in capacity planning, managers should pay attention to
the possible agency conflicts between the firm owner and the lender. Relative to the firm owners,
lenders are more concerned about the uncertainty embedded in the firms profitability, simply
because they may have substantial losses if the profit is low. The optimal capacity choice should
balance the interests of firm owners and the concerns of potential lenders, so as to mitigate the
T
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potential agency cost. Meanwhile, managers should also stay conservative towards the tax
benefit associated with debt financing, as both the tax liability and the agency cost are also
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closely related to the tax rate. Moreover, with the development of financial market, it is possible
for managers to use financial hedging as an effective tool to tackle the agency problem in debt
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financing. However, to effectively deploy the financial hedging, managers must convince lenders
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of the commitment to the hedging scheme. For instance, a firm can commit to a prescribed
financial hedging scheme using a bond covenant, so as to avoid the possible speculation in the
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name of hedging. In addition, managers should also pay attention to impacts of the transaction
cost in financial hedging. The chosen capacity level should be adjusted slightly down as the
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Finally, this paper could not possibly cover all the issues related to capacity investment using
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debt financing. There are many issues that can motivate future research. First we note that this
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paper focuses on a monopolistic market scenario, in which a firm just makes an independent
capacity choice that maximizes its own profit. Future research could explore capacity planning
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under market competition using game theory, where a firm needs to make a capacity decision in
a competitive environment and needs to assess the reaction of the its competitors in terms of their
likely capacity choices. In this type of scenario it will also be interesting to investigate how the
market competition will affect the size of the agency cost, choice of optimal level of capacity, as
well as the efficacy of financial hedging at equilibrium. This paper has addressed the case of
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one-period debt finance with the focus on the effects of the agency problem. However, multi-
period debt financing is also common in practice and can be an interesting area for further
dynamic risk assessment of the firm, which often needs to take into account the historical
performance of the firm. Finally, as shown by Gamba and Triantis (2014), the personal tax rate
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of shareholders can also be considered in corporate risk management, since this indirectly affects
shareholders tax liability for dividends received. The multi-period problem will obviously
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introduce an extra dimension for research in this filed and may well lead to some very interesting
results.
Acknowledgements
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The authors would like to thank the Editor and the anonymous referees for their helpful
comments and suggestions. We also gratefully acknowledge support from the National Natural
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Science Foundation of China (NSFC No. 71601159, 71571194, 71672074) and from a research
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Case 1
(1) ; or
(2) ; or
39
ACCEPTED MANUSCRIPT
(3)
(1) ; or
(2)
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(1) ; or
Case 2 (2)
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US (1)
(2)
; or
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Case 3
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(1) ; or
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(2)
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where , , ,
( )
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and
.
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, ,
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ACCEPTED MANUSCRIPT
and [ ] .
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Online Appendix
Appendix B: Proofs
Proof of Proposition 1:
The firms repayment at time 1 is contingent on the realization of the market size. Specifically,
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when the realized market size is high, the realized sales revenue would fulfill the debt holders
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loan plus the interest. In other words, we have ; or, equivalently,
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. The firms repayment at time 1 then is When the realized
market size is low, i.e., . The realized revenue of the firm may not be able to fulfill the debt
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obligation. Depending on the established capacity level, the firms repayment at time 1 can be
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written as:
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{
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Note that the firm can earn a positive revenue even when the realized market size is low. In other
words, the firm will choose the capacity to be lower than or equal to . Then, equation (4) can be
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re-written as follows:
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Using the expression of , the above equation can be re-organized in the following two cases,
Case 1:
In this case, the fairly priced borrowing rate can be obtained by solving the following equation:
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Case 2:
The fairly priced borrowing rate can be obtained by solving the following equation:
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Solving this equation, we can obtain the required borrowing rate:
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Summarizing the results, we know that Proposition 1 is true.
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Proof of Proposition 2:
We firstly analyze the analytical expression of the firms profit. When the realized market size is
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When the realized market size is low, the firms debt-free profit depends on the capacity level:
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[ ]
{
We now discuss the optimal capacity and firms profit under two different scenarios:
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Scenario 1:
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The optimal capacity level can be obtained by solving the maximization problem:
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Now, the relationship between and , which depends on the probability , is given as
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follows:
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Then, the corresponding optimal debt-free profit after tax of the firm in this scenario will be
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possible capacity in this scenario. Then the firm will optimally choose the capacity , since the
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It then follows that:
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When US
, it is obvious that the firm chooses to invest . The firms
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expected profit thus is
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]
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Scenario 2:
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The optimal capacity level can be obtained by solving the maximization problem:
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The first and second order derivatives of with respect to can then be calculated:
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From the first and second order derivatives, the unconstrained optimal capacity level is
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We can now compare with .
[
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[ ( )
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[ ] ]
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To summarize, the relationship among and is given as follows.
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{
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Next, the corresponding debt-free profit of the firm for different possible value of in this
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scenario will be discussed:
] ,
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[ ]
[ ]
As , we have
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When , the firm will optimally choose to invest since the profit
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When , we have
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[ ]
Now define ,
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. As discussed before, the optimal capacity choice then depends on the values
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of , and .
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Depending on the values of , and , We need to differentiate three cases. We will focus
on the Case 1. For Case 2 and Case 3 in Table 1, the proof can be obtained similarly.
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Case 1:
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Subcase 1: .
In this subcase, optimal capacity can be obtained by comparing the value of and . It is
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clear that
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Subcase 2:
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Subcase 3:
In this subcase, the optimal capacity can be obtained by comparing the value of and .
) . Otherwise,
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. Thus, in this subcase we have
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{
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{
Subcase 4:
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In this subcase, the optimal capacity can be obtained by comparing the values of and .
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{
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{
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results, Proposition 2(i) and (iii) can be obtained. Then, substituting the optimal capacity into the
Proposition 1, the corresponding borrowing rate can be derived (Proposition 2(ii)). As the
borrowing rate increases in the capacity level, the borrowing rate reaches the upper limit when
the capacity level is , which is the largest possible capacity that the firm can choose.
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Proof of Proposition 3
integration as follows:
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Then, we have the following inequalities:
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{ [ ] }
[ ]
it must be unique. Next we prove that such a solution must exist. Notice that is an
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That is, . Therefore, a positive solution must exist for the equation
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Thus,
( )
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( )[ ]
( )
[ ][ ]
[ ][ ]
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( )
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Together with the fact that , we know that .
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(ii) By definition, it is straightforward to verify that solves equation (4).
know that
any :
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. Moreover, one can easily verify the following inequality for
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[ ] [ ( )]
( )
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Proof of Lemma 1
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[ ( )] [ ( )] (Ingersoll 1989).
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