Managing Capital Market Frictions via Cost-Reduction Investments

Abstract

This research explores a firm’s process investment decision to reduce its unit production cost in the presence of capital market frictions, prior to making a production decision. This investment depletes the firm’s risk-free assets and creates two potentially counteracting effects: an operational effect associated with unit production cost reduction and a friction effect that captures the change in financing costs when the firm has to borrow money. Based on interactions of these two effects, we find parametric conditions when investment is optimal and show that the benefit from investing in cost reductions may increase with the level of market frictions, particularly, when the firm’s initial unit cost and capital are both sufficiently low and the investment’s impact on the unit cost is sufficiently high. We further find that technology uncertainty mitigates the impact of market friction on the benefit of investing, whereas demand uncertainty increases the feasible parameter space where the investment is optimal.