TY - UNPB

T1 - When are capital structure decisions nonseparable from production planning?

T2 - the case of generalized royalty-based hybrid finance

AU - Kaivanto, Kim

AU - Zinober, Alan

PY - 2015

Y1 - 2015

N2 - The well-known result that capital structure is irrelevant for firm value follows from a set of assumptions conducive to theoretical analysis. In this note we explore the implications of relaxing one of these assumptions: the independence of cash flows from capital structure. Unlike debt and equity, funding that is accompanied by a royalty payment obligation has the effect of increasingmarginal cost, to which a profit-maximizing firm responds by reducing output, violating the independence assumption. We study the effect on optimal production plans of generalized royalty payment obligations in which the royalty rate need not be constant across partitions of cumulative output, resulting in piece-wise linear cumulative royalty schedules that are not everywhere differentiable. The associated optimization problem for intertemporal production planning is nonstandard as it is not time separable. Here we solve this nonstandard problem by formulating an equivalent problem that in turn can be solved by the Pontryagin Maximum Principle using numerical techniques. When generalized royalty-based finance is included in thefinancing mix, the optimal production plan is non-trivially related to capital structure and capital structure is relevant to firm value. Unless the financing mix is restricted to debt and equity, financing decisions and production planning decisions cannot be undertaken independently in general.

AB - The well-known result that capital structure is irrelevant for firm value follows from a set of assumptions conducive to theoretical analysis. In this note we explore the implications of relaxing one of these assumptions: the independence of cash flows from capital structure. Unlike debt and equity, funding that is accompanied by a royalty payment obligation has the effect of increasingmarginal cost, to which a profit-maximizing firm responds by reducing output, violating the independence assumption. We study the effect on optimal production plans of generalized royalty payment obligations in which the royalty rate need not be constant across partitions of cumulative output, resulting in piece-wise linear cumulative royalty schedules that are not everywhere differentiable. The associated optimization problem for intertemporal production planning is nonstandard as it is not time separable. Here we solve this nonstandard problem by formulating an equivalent problem that in turn can be solved by the Pontryagin Maximum Principle using numerical techniques. When generalized royalty-based finance is included in thefinancing mix, the optimal production plan is non-trivially related to capital structure and capital structure is relevant to firm value. Unless the financing mix is restricted to debt and equity, financing decisions and production planning decisions cannot be undertaken independently in general.

KW - production planning

KW - capital structure

KW - separability

KW - Pontryagin Maximum Princi- ple

KW - numerical methods

KW - royalty-based finance

KW - hybrid instruments

M3 - Working paper

T3 - Economics working paper series

BT - When are capital structure decisions nonseparable from production planning?

PB - Lancaster University, Department of Economics

CY - Lancaster

ER -