Economic Evaluation of Scale Dependent Technology Investments

Abstract

W e study the effect of financial risk on the economic evaluation of a project with capacity decisions.Capacity decisions have an important effect on the project's value through the up-front investment, the associated operating cost, and constraints on output. However, increased scale also affects the financial risk of the project through its effect on the operating leverage of the investment. Although it has long been recognized in the finance literature that operating leverage affects project risk, this result has not been incorporated in the operations management literature when evaluating projects.We study the decision problem of a firm that must choose project scale. Future cash flow uncertainty is introduced by uncertain future market prices. The firm's capacity decision affects the firm's potential sales, its expected price for output, and its costs. We study the firm's profit maximizing scale decision using the CAPM model for risk adjustment.Our results include that project risk, as measured by the required rate of return, is related to the inverse of the expected profit per unit sold. We also show that project risk is related to the scale choice. In contrast, in traditional discounted cash flow analysis (DCF), a fixed prescribed rate is used to evaluate the project and choose its scale. When a fixed rate is used with DCF, a manager will ignore the effect of scale on risk and choose suboptimal capacity that reduces project value. S/he will also misestimate project value.Use of DCF for choosing scale is studied for two special cases. It is shown that if the manager is directed to use a prescribed discount rate that induces the optimal scale decision, then the manager will greatly undervalue the project. In contrast, if the discount rate is set to the risk of the optimally-scaled project, the manager will undersize the project by a small amount, and slightly undervalue the project with the economic impact of the error being small. These results underline the importance of understanding the source of financial risk in projects where risk is endogenous to the project design.

Panarchy: Discontinuities Reveal Similarities in the Dynamic System Structure of Ecological and Social Systems

“…Bessey (2002) asserts that temporal and spatial discontinuities are fundamental elements of system structure. Lederer and Mehta (2005) have demonstrated that the increased scale of technology projects produces increased risk via pressure on the operating leverage of the investment. They assert that scale is typically ignored in most financial analyses, which results in a miscalculation of the effect of scale on value and suboptimal scale decisions.…”

Interdisciplinary and Interorganizational Research: Establishing the Science of Enterprise Networks

“…Although scale, and the resulting operating leverage, of investment have been viewed in the finance literature as an important dimension of risk (Fama and French 1992), this issue has not been addressed in the operations management literature for evaluation of projects. Lederer and Mehta (2005) study the decision problem of a firm that must choose project scale since it affects the firm's potential sales, its expected price for output, and its costs. They use the Capital Asset Pricing Model to show that project risk and the resulting value of a project are related to the scale choice.…”

The relationship between operating leverage and financial leverage

“…They show that DOL (or f ) has a negative effect on DFL, that is, DOL crowds out DFL, or DOL and DFL are substitutes, consistent with the ‘leverage substitution’ hypothesis. Their model has two weaknesses: (i) the firm has no exit (or abandonment) option, which is a violation of limited liability; and (ii) they assume DOL is synonymous with f (fixed cost per unit of capacity), which ignores the important role of capacity choice in determining DOL (Huffman, ; Carlson et al ., ; Lederer and Mehta, ; Kumar and Yerramilli, ); thus, they ignore the firm's role in setting DOL (as capacity is generally chosen by the firm).…”