Is Operating Flexibility Harmful Under Debt?

Abstract

We study the inefficiencies stemming from a firm's operating flexibility under debt. We find that flexibility in replenishing or liquidating inventory, by providing risk-shifting incentives, could lead to borrowing costs that erase more than one-third of the firm's value. In this context, we examine the effectiveness of practical and widely used covenants in restoring firm value by limiting such risk-shifting behavior. We find that simple financial covenants can fully restore value for a firm that possesses a midseason inventory liquidation option. In the presence of added flexibility in replenishing or partially liquidating inventory, financial covenants fail, but simple borrowing base covenants successfully restore firm value. Explicitly characterizing optimal covenant tightness for all these cases, we find that better market conditions, such as lower inventory depreciation rate, higher gross margins, or increased product demand, are typically associated with tighter covenants. Our results suggest that inventory-heavy firms can reap the full benefits of additional operating flexibility, irrespective of their leverage, by entering simple debt contracts of the type commonly employed in practice. For such contracts to be effective, however, firms with enhanced flexibility and/or operating in better markets must also be willing to abide by more and/or tighter covenants. AbstractWe study the inefficiencies stemming from a firm's operating flexibility under debt. We find that flexibility in replenishing or liquidating inventory, by providing risk shifting incentives, could lead to borrowing costs that erase more than a third of the firm's value. In this context, we examine the effectiveness of practical and widely used covenants in restoring firm value by limiting such risk shifting behavior. We find that simple financial covenants can fully restore value for a firm that possesses a mid-season inventory liquidation option. In the presence of added flexibility in replenishing or partially liquidating inventory, financial covenants fail, but simple borrowing base covenants successfully restore firm value. Explicitly characterizing optimal covenant tightness for all these cases, we find that better market conditions, such as lower inventory depreciation rate, higher gross margins or increased product demand, are typically associated with tighter covenants. Our results suggest that inventory-heavy firms can reap the full benefits of additional operating flexibility, irrespective of their leverage, by entering simple debt contracts of the type commonly employed in practice. For such contracts to be effective, however, firms with enhanced flexibility and/or operating in better markets must also be willing to abide by more and/or tighter covenants.

Agency cost of debt overhang with optimal investment timing and size

“…This is consistent with Moyen's () finding; in particular, she mentions ‘More investment flexibility magnifies the debt overhang cost’ (p. 435). A similar argument was made in the context of the risk‐shifting agency problem by MacKay () and Iancu, Trichakis, and Tsoukalas ().…”

Dynamic Pricing Under Debt: Spiraling Distortions and Efficiency Losses

“…Our results are consistent with anecdotal evidence in the popular press that documents underwhelming discounts or even price markups during GOB sales at Circuit City, Borders or Linens'n Things (see, e.g., Chang, 2009;Sakraida, 2011;White, 2016). 2 They are also aligned with the empirical study by Genesove and Mayer (1997), who find that homeowners with larger debt loads set higher 1 Financial covenants are common contingencies in debt contracts, requiring borrowers to maintain certain financial ratios, e.g., a maximum debt-to-equity ratio or a minimum cashflow-to-debt ratio (see Iancu et al, 2016 for a discussion).…”

Inventory, Risk Shifting, and Trade Credit

“…The agency conflict arises when the retailer, after observing initial sales, must decide whether to liquidate inventory or continue to operate. Iancu et al (2016) demonstrate that this conflict can be eliminated by a suitably designed financial covenant, which depends on the borrower's operational characteristics such as demand distribution, inventory depreciation, or profit margin. Our work is also related to that of Van Mieghem (2007) and Chod et al (2010), who examine the role of risk in multi-item newsvendor networks.…”

“…Second, we argue that trade credit mitigates the agency cost associated with other forms of debt, whereas Chod and Zhou do not consider trade credit at all. 3 Another recent paper that studies operational repercussions of financial leverage is by Iancu et al (2016), who consider a lending contract between a retailer and a bank that is collateralized by inventory. The agency conflict arises when the retailer, after observing initial sales, must decide whether to liquidate inventory or continue to operate.…”