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Stochastic capacity investment and technology choice in imperfect capital markets

Author: Boyabatli, Onur ; Toktay, L. BerilINSEAD Area: Technology and Operations Management Series: Working Paper ; 2007/47/TOM Publisher: Fontainebleau : INSEAD, 2007.Language: EnglishDescription: 60 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: This paper analyzes the impact of endogenous financing costs under capital market imperfections in a capacity investment setting. We focus on the strategic interaction between a single firm that decides on its technology choice (flexible vs dedicated), capacity level, and production quantities under budget and demand uncertainty, and a single creditor that provides funds to the firm to finance its operational investments. The creditor has perfect information about the firm and offers two loan commitment contracts to the firm, one for each technology. Capital market imperfections in the form of bankruptcy costs and underwriter fees impose financing frictions on the firm. We derive the creditor's contract decision and the firm's technology, capacity, production and external borrowing decisions in equilibrium. Our analysis contributes to the capacity investment literature by analyzing the effect of capital market imperfections (in the form of fixed bankruptcy cost and underwriter fee) on capacity investment and technology choice with endogenously determined financing costs. We demonstrate that the endogenous nature of financing costs in imperfect capital markets may modify or reverse conclusions concerning capacity investment and technology choice obtained under the perfect market assumption. For example, the value of flexible technology may increase with increasing demand correlation and decreasing demand variability. Even with identical cost structures, dedicated technology may be preferred to flexible technology.
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This paper analyzes the impact of endogenous financing costs under capital market imperfections in a capacity investment setting. We focus on the strategic interaction between a single firm that decides on its technology choice (flexible vs dedicated), capacity level, and production quantities under budget and demand uncertainty, and a single creditor that provides funds to the firm to finance its operational investments. The creditor has perfect information about the firm and offers two loan commitment contracts to the firm, one for each technology. Capital market imperfections in the form of bankruptcy costs and underwriter fees impose financing frictions on the firm. We derive the creditor's contract decision and the firm's technology, capacity, production and external borrowing decisions in equilibrium. Our analysis contributes to the capacity investment literature by analyzing the effect of capital market imperfections (in the form of fixed bankruptcy cost and underwriter fee) on capacity investment and technology choice with endogenously determined financing costs. We demonstrate that the endogenous nature of financing costs in imperfect capital markets may modify or reverse conclusions concerning capacity investment and technology choice obtained under the perfect market assumption. For example, the value of flexible technology may increase with increasing demand correlation and decreasing demand variability. Even with identical cost structures, dedicated technology may be preferred to flexible technology.

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