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Weekly UpdatesINTRODUCTION
The operations management and engineering economics literature has largely ignored corporate financing decisions on the assumption that a firm's optimal inventory level or production decisions can be fully financed by internal capital or in the capital market without affecting the operational decision. In reality, firms lace financial constraints; their development heavily depends on debt issues, bank loans, venture capital, or other external equity investments that may have a variety of costs due, for example, to direct sources such as fees and indirect costs such as financial distress. Another critical assumption in traditional models is that the firm's manager always acts in the shareholders's best interest. Corporate managers may, however, deviate from value-maximizing operational and financing decisions and pursue their own self-interests; hence, ignoring the effects of financial constraints and agency costs creates a gap between theoretical research and industrial reality.
In this article, we build on previous work (Xu and Birge 2004) that studied the interactive mechanism between a firm's production decision and its capital structure choice. We will review that analysis and consider the effect of different operating conditions on capital structure, including some empirical support of our predicted relationship between production margin and market leverage. We will then extend our model to incorporate the interest conflict between corporate managers and owners. Our results show the relevance of these agency effects for traditional engineering economic decisions, such as the scale of production operations. We believe that these results are significant and relative enough to warrant inclusion in industrial engineering curricula.
Although few researchers in the operations management community have incorporated financial considerations into inventory or production decisions, an extensive literature considers questions in inventory control, capacity expansion, and supply chain management. The vast majority of models for these decisions assume that the firm can always finance its optimal production or inventory level without considering financial constraints. In reality, many firms face financial constraints and critically depend on external capital. Debt, for example, is commonplace across all firms. According to data on all publicly held U.S. firms (Damodaran 2004), the average debt-to--market value leverage ratio is 27.28%, while the debt-to--book value leverage ratio is even higher at 52.53% of total company value. The Federal Reserve Bank (2004) also reports that the total amount of net bonds issued by domestic corporations was $608 billion in 2003, and the total amount of business loans of all commercial banks was $880 billion by June 2004.
While financial economists have long considered the effects of capital structure on firm valuation, they usually assume that investment or production decisions are exogenously determined. The seminal work by Modigliani and Miller (MM) (1958) provided some justification by showing that a firm's value is independent of its capital structure in a perfect capital market. MM theory directly leads to the separation between a firm's operational and financial decisions. Due to market imperfections, such as taxes, agency costs, and asymmetric information, however, the choice of a firm's capital structure may in fact be closely related to its production decisions.
Three major theories address market imperfections in the capital structure category. According to Modigliani and Miller's traditional trade-off model (1963), the chief benefit of debt is the tax advantage of interest deductibility, while the primary costs are those associated with financial distress and personal tax expenses. Jensen and Meckling (1976) initiated the agency cost approach and identified two types of conflicts: conflicts between shareholders and managers, because managers only hold part of the residual claim, and conflicts between debt holders and equity holders because the debt contract gives equity holders an incentive to invest sub-optimally. Myers and Majluf (1984) also provide a pecking order theory of capital structure choice created by the presence of information asymmetries between the firm and its potential financiers. In this theory, external funds are less desirable because informational asymmetries imply that external funds are undervalued in relation to the degree of asymmetry. We refer to Harris and Raviv (1991) for a general review of these theories of capital structure.
More recently, several studies in the operations management community have addressed the interface between operations management and finance. Among these analyses, Lederer and Singhal (1994) consider joint financing and technology choices when making manufacturing investments and show that considerable value can be added to investments through financing decisions. Birge and Zhang (1999) seek to use option theory to introduce risk into inventory management. In another example, Birge (2000) adapts contingent claim pricing methods to incorporate risk into a capacity planning model. Other papers include Babich and Sobel (2004), which examines the relationship between operational decisions and the timing of an IPO for a startup firm, and Buzacott and Zhang (2004), which attempts to incorporate asset-based financing into production decisions. These studies do not, however, consider optimal capital structure or discuss the cost of debt.
In a previous paper (Xu and Birge 2004), we described a simplified model of production and financing decisions based on an extension of the news vendor model. This model incorporates the tax shield advantages of debt and the costs of bankruptcy in an integrated framework for decision-making. In this article, we explore additional characteristics of that model in response to changing parameters and show how capital structure can vary as a function of production margin. We also provide some empirical support for an observation that market leverage may have a U shape as a function of production margin, where leverage increases both as margins decline to zero and rise to one.
Many operations management and finance models, including our previous analysis, assume that corporate managers always act in the shareholders' best interest. For a given compensation contract, however, managers have incentive to take corporate actions that maximize their individual utility. These decisions may not be consistent with firm-value maximization. The second part of this article proceeds to consider the effects of agency costs, in particular, the interest misalignment between shareholders and managers, on the firm's optimal production and financial decisions.
The interest conflicts between principal and agent play an important role in corporate finance. Jensen and Meckling (JM) (1976) challenge the MM proposition that investment decisions are independent of capital structure. They use the agency theory framework to study the effect on investment and financing decisions of conflicts of interest among managers, bond holders, and stockholders. Many others in the finance literature have followed JM in investigating such effects of agency costs.
Recognizing operations management as a natural area for application of the principal-agent paradigm, agency models have emerged in the marketing-operations interface area. Assuming the marketing and manufacturing managers of the firm act in their self-interest, Porteus and Whang (1991) seek incentive structures that maximize the residual return to the owner of the firm. Plambeck and Zenios (2000) develop a dynamic principal-agent model and identify an incentive-payment scheme that aligns the objectives of the owner and manager. Chen (2000, 2005) considers the problem of sales force compensation by considering the impact of sales force behavior on a firm's production and inventory systems. Overall, this line of literature mainly focuses on the marketing-operations interface without considering the effects of managerial compensation on the firm's production and financial decisions.
To analyze the effects of agency cost on the firm's decisions, we extend our model by considering the structure of managerial compensation. With the assumption that the manager acts on his own behalf given the compensation plan in place, we show that the manager prefers aggressive investment decisions and conservative debt policy. A manager's self-interest maximization causes his actions to deviate from firm-optimal decisions, lowering the value of the company. We demonstrate that a manager's production decisions are positively correlated with the weight of performance-based bonus compensation, while the debt usage increases as the share of managerial equity ownership increases. Our model also suggests that agency costs can be mitigated by aligning the interests between the manager and shareholders and that low-margin producers are most susceptible to value loss from misaligned managerial incentives.
The article is organized as follows. In the next section, we review our previous model to show the effects of financial constraints on firm production. We explore the effect of varying operating conditions on the production and financial decisions and provide some empirical results about the relationship between capital structure and operating margin. We then model the corporate manager's incentive plan as the sum of fixed basic salary, performance-based bonus, and equity ownership. The following section contains the results and analysis of a numerical example.
PRODUCTION UNDER FINANCIAL CONSTRAINTS AND DEBT FINANCING
The traditional production-related literature in operation management assumes that the firm faces no financial constraints and can secure funds to adopt an optimal production policy based exclusively on information related to the production system. As we have stated earlier, in practice, however, production decisions are constrained by financial situations.
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