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Financing capacity investment under demand uncertainty

Author

Listed:
  • Francis de Véricourt

    (ESMT European School of Management and Technology)

  • Denis Gromb

    (INSEAD)

Abstract

This paper studies the interplay between the operational and financial facets of capacity investment. We consider the capacity choice problem of a firm with limited liquidity and whose access to external capital markets is hampered by moral hazard. The firm must therefore not only calibrate its capacity investment and the corresponding funding needs, but also optimize its sourcing of funds. Importantly, the set of available sources of funds is derived endogenously and includes standard financial claims (debt, equity, etc.). We find that when higher demand realizations are more indicative of high effort, debt financing is optimal for any given capacity level. In this case, the optimal capacity is never below the efficient capacity level but sometimes strictly above that level. Further, the optimal capacity level increases with the moral hazard problem's severity and decreases with the firm's internal funds. This runs counter to the newsvendor logic and to the common intuition that by raising the cost of external capital and hence the unit capacity cost, financial market frictions should lower the optimal capacity level. We trace the value of increasing capacity beyond the efficient level to a bonus effect and a demand elicitation effect. Both stem from the risk of unmet demand, which is characteristic of capacity decisions under uncertainty.

Suggested Citation

  • Francis de Véricourt & Denis Gromb, 2014. "Financing capacity investment under demand uncertainty," ESMT Research Working Papers ESMT-14-03, ESMT European School of Management and Technology.
  • Handle: RePEc:esm:wpaper:esmt-14-03
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    File URL: http://static.esmt.org/publications/workingpapers/ESMT-14-03.pdf
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    References listed on IDEAS

    as
    1. Onur Boyabatlı & L. Beril Toktay, 2011. "Stochastic Capacity Investment and Flexible vs. Dedicated Technology Choice in Imperfect Capital Markets," Management Science, INFORMS, pages 2163-2179.
    2. Joaquín Poblete & Daniel Spulber, 2012. "The form of incentive contracts: agency with moral hazard, risk neutrality, and limited liability," RAND Journal of Economics, RAND Corporation, vol. 43(2), pages 215-234, June.
    3. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October.
    4. Jean Tirole, 2006. "The Theory of Corporate Finance," Post-Print hal-00173191, HAL.
    5. Gromb, Denis & Martimort, David, 2007. "Collusion and the organization of delegated expertise," Journal of Economic Theory, Elsevier, vol. 137(1), pages 271-299, November.
    6. Tinglong Dai & Kinshuk Jerath, 2013. "Salesforce Compensation with Inventory Considerations," Management Science, INFORMS, pages 2490-2501.
    7. Lode Li & Martin Shubik & Matthew J. Sobel, 2013. "Control of Dividends, Capital Subscriptions, and Physical Inventories," Management Science, INFORMS, pages 1107-1124.
    8. Oyer, Paul, 2000. "A Theory of Sales Quotas with Limited Liability and Rent Sharing," Journal of Labor Economics, University of Chicago Press, vol. 18(3), pages 405-426, July.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Capacity; optimal contracts; financial constraints; newsvendor model;

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