Production Flexibility, Risk Shifting And Capital Structure

We analyze the effect of production flexibility on optimal leverage ratio. A firm can operate at two production levels, high and low, and operating flexibility is measured by the cost of switching from one level to the other. Greater operating flexibility has two opposing effects – value-enhancing and risk-shifting, resulting in higher and lower optimal leverage ratio respectively. The overall effect is ambiguous, and depends on which effect dominates. We demonstrate that optimal leverage ratio can be either increasing or decreasing in operating flexibility, depending on input parameters such as degree of output adjustment, profit margin, growth rate, tax rate and bankruptcy cost. When these parameters are large (small), optimal leverage ratio is an increasing (a decreasing) function of operating flexibility. An empirical prediction of the model is that, for large firms, optimal leverage ratio will be a decreasing function of operating flexibility, consistent with previous findings.