Is Operating Flexibility Harmful Under Debt?

Dan A. Iancu (), Nikolaos Trichakis () and Gerry Tsoukalas ()
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Dan A. Iancu: Stanford Graduate School of Business, Stanford University, Stanford, California 94305
Nikolaos Trichakis: Harvard Business School, Harvard University, Cambridge, Massachusetts 02163
Gerry Tsoukalas: The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104

Management Science, 2017, vol. 63, issue 6, 1730-1761

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.

Keywords: operating flexibility; inventory management; finance; covenants; debt (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (17)

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