Stochastic Capacity Investment and Flexible vs. Dedicated Technology Choice in Imperfect Capital Markets

This paper analyzes the impact of endogenous credit terms under capital market imperfections in a capacity investment setting. We model a monopolist firm that decides on its technology choice (flexible versus dedicated) and capacity level under demand uncertainty. Differing from the majority of the stochastic capacity investment literature, we assume that the firm is budget constrained and can relax its budget constraint by borrowing from a creditor. The creditor offers technology-specific loan contracts to the firm, after which the firm makes its technology choice and subsequent decisions. Capital market imperfections impose financing frictions on the firm. Our analysis contributes to the capacity investment literature by extending the theory of stochastic capacity investment and flexible versus dedicated technology choice to understand the impact of capital market imperfections, and by analyzing the impact of demand uncertainty (variability and correlation) on the operational decisions and the performance of the firm under different capital market conditions. We demonstrate that the endogenous nature of credit terms in imperfect capital markets may modify or reverse conclusions concerning capacity investment and technology choice obtained under the perfect market assumption and we explain why. The theory developed in this paper suggests some rules of thumb for the strategic management of the capacity and technology choice in imperfect capital markets.