OPTIMAL DECISION-MAKING IN MANUFACTURING INDUSTRY UNDER BUSINESS RISK

Abstract

In the modern global economy, emerging economies have become the main source of manufactured goods to supply the advanced economies. The profits of a manufacturing firm normally increase in the amount it can produce and sell. However, in an environment of uncertainty, it is not always optimal for a manufacturing firm in emerging economies to accept big production orders even though this might mean higher revenues. This is because a corresponding higher operating leverage will necessarily increase business risk and the resulting discount rate, which may result in a lower firm value. In this study, we provide a structural framework targeting this problem where demand is stochastic, discount rate is endogenously determined based on business risk and operating leverage. We use lithium battery, an essential component in electric and hybrid cars, to demonstrate how the framework is developed and implemented. Our model helps decide the optimal production capacity as the result of the cost structure, risk aversion, and value maximization. We show how the valuation process is carried out in a theoretically consistent manner. Our framework may be extended for different sectors in emerging economies when production decisions are to be made under uncertainty.