Production, Capacity, and Liquidity of a Financially Constrained Firm

Abstract

This paper studies the optimal coordination of operational and financial decisions of a firm with restricted and costly access to capital markets. The firm dynamically manages its production capacity and cash reserve by making production, divestment, investment, dividend, and capital injection decisions each period. The paper characterizes the optimal policy and shows that it corresponds to the optimal exercising of the real options embedded in the capacity and cash. A distinguishing feature of these real options is that they are embedded in each other, reflecting the fact that in a dynamic setting, exercising a real option in capacity or cash generates additional capacity or cash, thus additional real options. As the capital market becomes less frictional, the values of the real options in capacity and cash increase, and the firm is more likely to raise capital but less likely to issue dividends to exploit the higher values of the real options. As the firm places more emphasis on maximizing the operating profit rather than the shareholder's value, the values of the real options in capacity increase, and the firm exhibits a more aggressive investment attitude.