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Accepted Manuscript

Capacity Decisions with Debt Financing: The Effects of Agency


problem

Jian NI , Lap Keung CHU , Qiang LI

PII: S0377-2217(17)30186-8
DOI: 10.1016/j.ejor.2017.02.042
Reference: EOR 14284

To appear in: European Journal of Operational Research

Received date: 24 August 2015


Revised date: 27 February 2017
Accepted date: 28 February 2017

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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Capacity Decisions with Debt Financing: The Effects of Agency

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

Department of Industrial and Manufacturing Systems Engineering, University of Hong Kong,


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Hong Kong SAR

Tel.: +852 28592590.


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E-mail: lkchu@hkucc.hku.hk
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** Qiang LI (Corresponding author)


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Institute of Physical Internet, Jinan University (Zhuhai Campus), Zhuhai, China

Department of Industrial and Manufacturing Systems Engineering, University of Hong Kong,


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Hong Kong SAR

Tel.: +852 92255918.

E-mail: liqiang@connect.hku.hk

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Capacity Decisions with Debt Financing: The Effects of Agency Problem

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

additional investment in materials, equipment, human resources, etc., so as to facilitate the

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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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loans for funding their capacity investments.

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

optimal capacity decision of the firm.


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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)

alternatively employed an exponential utility to explore the relationship between operational

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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Financing, in particular, debt financing, is an important component of a firms financial

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

firms (retailer) competing against each other (Yang et al. 2015).

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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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the production stage, should shape the optimal technology choice.


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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

section 3, we discuss an expansion of the model that is more complicated. Numerical

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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2.1. The basic framework

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

should be calculated as . To simplify the subsequent analysis, we assume that the

uncertain market size takes the following binary form ( ):

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{ (1)

where ( ) is the probability of having a good market prospect ( ), while

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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To appropriately consider firms operational policy under debt financing, it is necessary to

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

question of this section.


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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

usually have , with being the risk premium charged.

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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:

In other words, is the operating revenue


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net of the debt service payment
(2)
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, and the equity holder can gain a positive income only when is positive. If the borrowing

rate is exogenously determined, to maximize the equity holders value the firm will make the
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optimal capacity decision as follows:


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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.

(2012), Cai et al. (2014), and Jing and Seidmann (2014).

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Then, the CSV approach determines the required borrowing rate as follows:

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[ ] [ ( )] (4)

where is the Heaviside function:

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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

perfectly competitive financial market.


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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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reorganization is a topic worth future investigation.

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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Modigliani-Miller framework. As a result, we do need to incorporate both the firms financing

and investment decisions all together in a model.


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2.3. The optimal capacity level with debt financing


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It is, of course, more difficult to analyze the problem (5) with the constraint (4) due to the

discontinuity of the Heaviside function . To analytically derive some managerial insights, we


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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

debt holder will be adjusted in response to changes of the capacity level .

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Proposition 1 then shows that the unique borrowing rate that satisfies the constraint (4) can

be expressed as a function of the capacity level .

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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borrowing rate is risk-free: . Third, if the product is not highly profitable


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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

independent of capital structure. However, the Modigliani-Miller theory is challenged by Jensen

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

higher borrowing rate.

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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

where the tax rate is small ( ) such that


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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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Online Appendix. In what follows, we summarize the main results in Proposition 2.


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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,

, ( ( )), and . When

the optimal capacity is ( ), the borrowing rate is . When the optimal capacity

is ( ), the borrowing rate is . Otherwise ( or ), the borrowing

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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

Table 1 in the Appendix.

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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

or can be considered in a same manner). To start with, consider the


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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:

[ (( ) ) ] . In other words, the firm

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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

T
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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short of that of the first-best: . As shown in Table 1, similar

situation happens also for the cases (i) , and (ii)


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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

19
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compensation for bearing the credit risk, a relatively high borrowing rate is charged:

( ) . In response, the firm will optimally

choose the capacity level , which deviates significantly

from the first-best level . Such a distortion can also give rise to an agency cost:

T
IP
.

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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 (

) is analogous to the case of . For the second scenario


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( or ), the firm will choose the optimal capacity , where the good
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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

would choose a capacity level deviating from its first-best.


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3. Generalization and analysis

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

generalized situation is discussed in this section.

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

normal, exponential, uniform distributions, among others (Froot et al. 1993).


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3.1. Some analytical discussion

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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modeled by a generalized distribution with an increasing hazard function. A common

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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constraint (2) and debt-financing constraint (4) are satisfied.

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

auxiliary function as follows ( ):

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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 .

One can directly calculate the first-order derivative of : [ ][

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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

, which has a unique solution given the increasing hazard function .


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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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increasing function of the capacity level chosen by the firm.


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Proposition 3. (i) Suppose that the capacity level chosen by the firm is [
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]. There exists a unique ] that solves the equation ,


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where satisfying for . The function is both increasing

and convex, i.e., and .

(ii) Once is obtained, then the borrowing rate as a function of the chosen capacity

can be expressed as . Besides, the borrowing rate will convexly increase

with , i.e., and . In addition, .

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An interesting result reported in Proposition 3 is that is an increasing convex function of

. 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).

So the profit function is a concave function of the capacity level.

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

more risk, which may hurt the debt holder.

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Lemma 1. If is a mean-preserving spread of , then [ ] [ ].

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

uncertainty given the debt.


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Taking more risk is absolutely not in the interest of the debt holder. As indicated by the CSV

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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concern into the decision making of the capacity investment.

3.2. Financial hedging opportunity

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

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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

T
IP
futures, options, and/or swaps), this setting allows us to better understand what role financial

hedging will play in making capacity decisions.

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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

( ) , where ( ) and ( ) are the standard deviation of and , respectively. As


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is common in operations-finance literature (e.g., Ding et al. 2007, Caldentey and Haugh 2009,

Chod et al. 2010), the financial market is assumed to be arbitrage-free, that is, [ ] . The
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final payoff of the hedging position at expiration is ( ) (Duffie 2001).


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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

exchange-traded security, is simply the proportional transaction cost. For an over-the-counter


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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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hedging would arise no matter it is a long position ( ) or a short position ( ); so the

cost of financial hedging is calculated as | |, where | | . Thus, the net payoff

of the hedging position per unit capacity is ( ) | |, and the debt-free profit with

financial hedge writes

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(6)

where ( ) | | . Given financial hedging, the capacity investment

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

CR
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

discussed in the next section.


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3.3. Numerical study

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
AC

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

equity holders, that is, [ ], where the maximal is achieved

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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

clearing price should be higher than , we set and , approximately reflecting a

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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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Louveaux 2011). It involves approximating the continuous-distributed random variables through


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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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present a representative set of the sensitivity analysis.

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

sensitivity analysis are summarized in Figure 1.


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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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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

IP
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

approach the expected bankruptcy cost can be estimated as [ ( )]. We add

this bankruptcy cost to


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and plot the results (actual profit plus bankruptcy cost) in the dotted

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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discussion in section 2.3.


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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
AC

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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under debt financing.

Besides, panel (c) further confirms that the agency cost should dominate the bankruptcy cost,
AC

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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Figure 3: Sensitivity analysis on corporate tax rate


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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
IP
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
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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

the correlation, the more effective is the financial hedging.


AC

However, financial hedging would be costly in some cases. Thus, it is worthwhile to

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
AN
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.
AC

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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IP
that the impacts of changes in corporate tax rate under the agency conflicts should be more

complicated than what the Modigliani-Miller theorem suggests.

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Next, we show that the agency cost can be controlled by financial hedging, and the

US
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)

and Chen and King (2014).

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

T
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

financial hedging and operational flexibility.

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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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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transaction cost increases.

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
38
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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

research. An important consideration in modeling a multi-period financing problem is the

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

T
IP
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

CR
introduce an extra dimension for research in this filed and may well lead to some very interesting

results.

Acknowledgements
US
AN
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
M

Science Foundation of China (NSFC No. 71601159, 71571194, 71672074) and from a research
ED

grant received from The University of Hong Kong (Code 201409176228).

Appendix A: Summary of the remaining analytical results for Proposition 3


PT

Table 1: Summary of optimal capacity values and corresponding conditions


CE

Optimal Optimal Borrowing


capacity profit rate Condition
AC

Case 1
(1) ; or

(2) ; or

39
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(3)

(1) ; or
(2)

T
IP
(1) ; or
Case 2 (2)

CR
US (1)
(2)
; or
AN

Case 3
M

(1) ; or
ED

(2)
PT

where , , ,

( )
CE

and

.
AC

Besides, the following first-order approximation of the profits holds when :

, ,

40
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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,

T
when the realized market size is high, the realized sales revenue would fulfill the debt holders

IP
loan plus the interest. In other words, we have ; or, equivalently,

CR
. 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

US
obligation. Depending on the established capacity level, the firms repayment at time 1 can be
AN
written as:
M

{
ED

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
PT

re-written as follows:
CE
AC

Using the expression of , the above equation can be re-organized in the following two cases,

depending on the capacity level:

Case 1:

In this case, the fairly priced borrowing rate can be obtained by solving the following equation:

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from which we can immediately obtain the required borrowing rate .

Case 2:

The fairly priced borrowing rate can be obtained by solving the following equation:

T
IP
CR
Solving this equation, we can obtain the required borrowing rate:

US
Summarizing the results, we know that Proposition 1 is true.
AN
Proof of Proposition 2:

We firstly analyze the analytical expression of the firms profit. When the realized market size is
M

high, given capacity level the firms debt-free profit is


ED

from which the firms debt-free profit after tax is


PT

[ ]
CE

When the realized market size is low, the firms debt-free profit depends on the capacity level:
AC

from which the firms debt-free profit after tax is

48
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[ ]
{

We now discuss the optimal capacity and firms profit under two different scenarios:

T
Scenario 1:

IP
The optimal capacity level can be obtained by solving the maximization problem:

CR

[ ]

The first and second order derivatives of US


with respect to now writes:
AN
[ ]
M
ED

The unconstrained optimal capacity level thus is


PT

Now, the relationship between and , which depends on the probability , is given as
CE

follows:
AC

Then, the corresponding optimal debt-free profit after tax of the firm in this scenario will be

given in the following.

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When , the unconstrained optimal capacity is larger than the largest

possible capacity in this scenario. Then the firm will optimally choose the capacity , since the

profit increases in when . The corresponding expected profit is

[ ]

T
IP
It then follows that:

CR
When US
, it is obvious that the firm chooses to invest . The firms
AN
expected profit thus is

[ ]
M

[
ED

]
PT

from which we have


CE

Scenario 2:
AC

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:

[ ]

T
IP
From the first and second order derivatives, the unconstrained optimal capacity level is

CR
We can now compare with .

[
US
AN
]

[ ( )
M

]
ED

Thus, the following relationship between and holds:


PT
CE

Now, we compare with :


AC

[ ] ]
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Since , the relationship between and can be explicitly expressed as follows:

T
To summarize, the relationship among and is given as follows.

IP
CR
{

US
Next, the corresponding debt-free profit of the firm for different possible value of in this
AN
scenario will be discussed:

When , the firm will optimally choose the capacity , as


M

the profit decreases in when . As , the corresponding profit is


ED

] ,
PT

When , the firm will optimally


CE

chooses to invest so as to maximize the profit, which can be calculated as


AC

[ ]
[ ]

As , we have

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When , the firm will optimally choose to invest since the profit

increases in when . The corresponding profit is

[ ]

[ ]

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IP
When , we have

CR
[ ]

Now define ,
US , and

. As discussed before, the optimal capacity choice then depends on the values
AN
of , and .
M

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.
ED

Case 1:
PT

Subcase 1: .

In this subcase, optimal capacity can be obtained by comparing the value of and . It is
CE

clear that
AC

It follows that . Thus, in this subcase we have and

Subcase 2:

In this subcase, one can easily verify that . Thus, , and

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Subcase 3:

In this subcase, the optimal capacity can be obtained by comparing the value of and .

It is clear that if and only if , where (

) . Otherwise,

T
. Thus, in this subcase we have

IP
{

CR
{

Subcase 4:
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In this subcase, the optimal capacity can be obtained by comparing the values of and .
AN

When and , we have . Otherwise, we have . Thus,


M

in this subcase we have


ED

{
PT

{
CE

Finally, define , , , and , and summing up the above


AC

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

(i) By definition, we know that any feasible capacity must satisfy . or

. We now prove that for . Re-write in terms of

integration as follows:

IP
Then, we have the following inequalities:

CR
{ [ ] }
[ ]

It then follows that when US


.
AN
As a result, if the equation , or has a positive solution,

it must be unique. Next we prove that such a solution must exist. Notice that is an
M

increasing function of for . It is already known that . Then, one

can easily verify the following inequality:


ED


PT

That is, . Therefore, a positive solution must exist for the equation

.
CE

Differentiating with respect to , we have .


AC

Thus,

( )

Similarly, we can obtain the following expression:

55
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( )[ ]
( )

For , we have the following inequality:

[ ][ ]

[ ][ ]

T
( )

IP
Together with the fact that , we know that .

CR
(ii) By definition, it is straightforward to verify that solves equation (4).

Obviously, and . As the borrowing rate is increasing with , we

know that

any :
US
. Moreover, one can easily verify the following inequality for
AN
[ ] [ ( )]

( )
M

It then follows that , which implies that .

Proof of Lemma 1
ED

Obviously, the function is a convex function, which in turn implies that

[ ( )] [ ( )] (Ingersoll 1989).
PT
CE
AC

56