Managing Capital Market Frictions via Cost-Reduction Investments
Asst. Prof. Dr. Fehmi Tanrısever, Department of Management, Bilkent University
April 20, Friday 13:30
Problem definition: We examine how the presence of capital market frictions influences the decision to invest in production cost reduction and the resulting production volume. This investment can increase the firm’s cash flow by increasing the profit margin, but it can also decrease the firm’s risk-free cash reserves and thus affect its exposure to capital market frictions.
Academic / Practical Relevance: Process improvement aimed at production cost reduction has generated myriad of theoretical questions about efficient investment options and capacity choices. From a managerial perspective, process improvement is a fundamental concern in operations strategy. Nevertheless, its analysis typically excludes financial constraints by assuming a perfect capital market.
Methodology: We formulate a two-stage profit maximization model in which a capital-constrained firm commits to a cost-reduction investment in the first stage in anticipation of its production decision in the second stage of this two-stage decision process. The firm considers capital market frictions when making decisions at each stage, while considering uncertainty in demand for its offering and in reducing its unit production cost.
Results: When a firm faces small initial capital and low pre-investment unit production costs, it can benefit from investing in production cost reduction in the presence of capital market frictions more so than in their absence. Moreover, uncertainty in the production cost reduction mitigates the impact of market frictions on the net benefit (i.e., additional profit), whereas demand uncertainty decreases the feasible parameter space where investing in production cost reduction is optimal.
Managerial Implications: A firm’s decision to invest in production cost reduction affects its operational and financial capabilities. Managers should thus consider this investment as an operational hedge not only against the uncertainty of matching supply and demand, but against exposure to capital market frictions and the resulting financial risk.
Keywords: cost-reduction investment, operational hedging, capital market frictions, OM-finance interface
Bio: Fehmi Tanrisever received his PhD degree in Supply Chain and Operations Management from the McCombs School of Business of the University of Texas at Austin in 2009. After receiving his PhD, he worked as an assistant professor of Operations Management and Finance at the Industrial Engineering and Innovation Sciences Department at Eindhoven University of Technology until 2013. His research interests include Start-up Operations and Risk Management, Clean Technology Development and Deployment, Supply Chain Finance, Commodity Risk Management and Operations-Finance Interface. He teaches graduate and undergraduate level courses in integrated operational and financial risk management, operations management, business finance and financial accounting.