Resource Flexibility and Capital Structure

This paper examines how the optimal investment in the capacity of flexible and nonflexible resources is affected by financial leverage and, conversely, how a firm's resource flexibility affects its optimal capital structure. We consider a two-product firm that invests in the optimal capacity of product-flexible and product-dedicated resources in the presence of demand uncertainty. Before investing in capacity, the firm issues the optimal amount of debt, trading off the tax benefit and lower transaction cost of debt financing against the cost of financial distress and the agency cost associated with leverage. We show that in the presence of debt, resource flexibility has benefits in addition to reducing the mismatch between supply and demand. Namely, resource flexibility mitigates the shareholder-debtholder agency conflict as well as the risk of costly default. Most interestingly, we show that resource flexibility mitigates the underinvestment problem because it reduces the probability that a firm will go bankrupt with some of its capacity being fully utilized. When lenders anticipate that a firm will choose a relatively flexible capacity mix, they should provide more favorable credit terms, to which the firm should respond by issuing more debt. The main empirical predictions are that resource flexibility is negatively related to the cost of borrowing and positively related to debt. This paper was accepted by Yossi Aviv, operations management.