On the Interplay of Production Flexibility and Financing Strategy

Abstract

We investigate how a levered firm may utilize production flexibility in response to market changes. Specifically, when the market price of the output falls below a threshold, equity holders, making operational decisions, either switch off production or default, and when the price rises above a threshold they switch on production provided the firm has not defaulted. Interestingly, we find that the firm's debt level affects how much production flexibility is used. We endogenize the firm's financing strategy and uncover that the effect of operational flexibility on financial leverage depends on the level of flexibility, measured by switching cost. When the switching cost is low, production flexibility complements the benefits of debt and thus financial leverage increases in production flexibility. As the switching cost increases to some intermediate level, the firm may have to reduce its debt usage more sharply to induce equity holders to implement the flexible production policy. However, if the switching cost exceeds a threshold, the firm forgoes production flexibility for high financial leverage, as the benefit of flexibility shrinks. Now, a substitution effect of flexibility on debt usage ensues. We provide a partial test of this new theory based on a unique iron and steel industry dataset that complements and extends prior empirical findings.