Operations and Finance Interactions
John R. BirgeUniversity of ChicagoUniversity of Chicago
Booth School of Business
MSOM INSEAD, July 2013 1© JRBirge
Overview: What to Remember?Overview: What to Remember?• Assuming long-term arbitrage is dangerous
– Systematic risk is different from idiosyncraticSy y– Requires some adjustment to MSOM model
• Assuming no arbitrage can create• Assuming no arbitrage can create computational efficienciesI i f t (i l) k t ti• In imperfect (i.e., real) markets, operations-finance interactions matter
f h f d h l h– for the firm and the supply chain• Operational-financial considerations can
– guide policy and explain empirical observations© JRBirge MSOM INSEAD, July 2013 2
Assuming No Arbitrage• Arbitrage: the ability to start out withArbitrage: the ability to start out with
(possibly nothing) and never lose and to make a profit in some future statesmake a profit in some future states
• Easy to miss because:i d i i d l “ fi ” d bin a pure decision model, “profit” needs to be
examined – often not really present• In particular, financial instruments should
not able to provide (sustainable) arbitrage
© JRBirge MSOM INSEAD, July 2013 3
Risk Implications• With risky returns, there is a difference
between what can be hedged (idiosyncratic) and what cannot be hedged (systematic)
• To (a diversified investor):
Hedged Un-Hedged
© JRBirgeMSOM INSEAD, July 2013
4
Hedged
Risk TakeawayTh t f i k tt• The type of risk matters:– Idiosyncratic risk (without other market
i f ti ) h ld t b i dimperfections) should not be priced– Systematic risk should be priced by investors at
the market price of riskthe market price of risk– Lumping systematic and idiosyncratic risk is
inconsistent with no arbitrageinconsistent with no-arbitrage • Paying more for a market item than others
illi t i dare willing to pay is dangerous© JRBirge MSOM INSEAD, July 2013 5
Risk-Neutral Pricing ConclusionRisk Neutral Pricing Conclusion(Inter-temporal CAPM)
• The market and idiosyncratic components of cash flows can be separated p
• The market components should be priced by the market price of risk (with the remainderthe market price of risk (with the remainder diversifiable)
• Simple changes of the probability• Simple changes of the probability distribution then give consistent results
© JRBirge MSOM INSEAD, July 2013 6
Implications for CapacityImplications for Capacity (JRB/MSOM 2000)
• USE CORRELATION TO THE MARKET?• USE CORRELATION TO THE MARKET?• Can measure for known markets (beta values)• If capacitated, depends on decisions
• Constrained resources capacity• Constrained resources - capacity• Correlations among demands
Revenue
A h t th d d di t ib ti t i k t l i l t b
DemandCapacity No revenue variation -
low discount
High revenue variation (risk) - high discount
• Approach: convert the demand distribution to a risk-neutral equivalent by removing the risk premium
– Capacity is like an option that can be priced using this approach
7/28/2013 MSOM 2013 7
Computing Capacity Value• Goal: Production value with capacity K
• Compute uncapacitated value based on CAPM:• S = e-r(T-t)c S dF(S )• St e ( )cTSTdF(ST)• where cT=margin,F is distribution (with risk aversion),• r is rate from CAPM (with risk aversion)
A S i kf l if i k• Assume St now grows at riskfree rate, rf ; evaluate as if risk neutral:
• Production value = St - Ct= e-rf(T-t)cTmin(ST,K)dFf(ST)• where Ff is distribution (with risk neutrality)
Capacity, K
V l T
Sales Potential, ST
Value at T
7/28/2013 J.R. Birge, Northwestern University 8
Computational Efficiencies• In capacity models (with log-normal demand):
– Demand distribution transformation is equivalent to a shift of capacity by the risk premium, e(rm-rf)(T-t)
• For the news vendor (JRB/Zhang, TEE1999), logic yields:
p− c ( )(T t) p− cFf (x
∗) =p c
p− s → F (e(rm−rf )(T−t)x∗) =p c
p− sor
x∗ e−(rm−rf )(T−t)F−1(p− c
)
© JRBirge MSOM INSEAD, July 2013 9
x = e ( m f )( )F (p− s ).
Implications for Flexibility p yResources(Aytekin/JRB 2004)( y )
• Suppose firms can invest in capacity in multiple locations to take advantage of market p gfluctuations (exchange rates/demand)
• Implication:Implication: – Can identify limited set of possible configurations
Can develop closed form expressions of value with– Can develop closed-form expressions of value with computable bounds
© JRBirge MSOM INSEAD, July 2013 10
Alternative Operations• Production Distribution
Domestic ???
Foreign
?
?ForeignAdvantage of foreign operations: When cost (exchange rate) is advantageous, can shift production.When cost (exchange rate) is advantageous, can shift production.
Excess capacity in D and F provide an option to shift production to the favorable location
© JRBirge UToronto 28 Oct , 2011
favorable location.
Valuing the Alternatives
• If sufficient flexible capacity, produce in the market with favorable exchange rateg
• Set thresholds for production shifts to overcome setup and changeover costsovercome setup and changeover costs.
• Shift production when limits are exceeded.G i l b l• Gain: natural balance.
• Cost: additional capacity and transaction.
© JRBirge UToronto 28 Oct , 2011
Value of Flexible CapacityValue of Flexible Capacity• Can evaluate the capacity as a perpetual option
using only correlation to the market for theusing only correlation to the market for the elimination of risk
• Value also increasing in the volatility of the• Value also increasing in the volatility of the exchange rate but reaches a limit:
© JRBirge UToronto 28 Oct , 2011
Markets Imperfections andMarkets Imperfections and Operations-Finance
• Without market imperfections, operational and financial can be separated p(Miller/Modigliani)
• Market imperfections make it less possibleMarket imperfections make it less possible to create perfect hedges
• Result is that operations and finance cannot• Result is that operations and finance cannot be separated
© JRBirge MSOM INSEAD, July 2013 14
Operations-Finance Links:pImplications for the Firm
• Imperfections:Imperfections: – Tax advantage of debt– Cost of financial distress (e g loss in default)Cost of financial distress (e.g., loss in default)
• Newsvendor extension (Xu/JRB 2004, NRL 2006, TEE 2008):TEE 2008):
*
max ( , ) [ ( )] ( )
[ ( )] ( )
xx
q
V x D px px cx rD f q dq
ps ps cx rD f q dq
τ
τ
∞= − − −
+ − − −
*
0( ) ( ) (1 )
. . (1 ) (1 )[1 ( )] ( )
b
b
b
q q
fq
qbf
pqf q dq pqf q dq cx r
s t D r D r F q pqf q dq
α
α
+ + − +
+ = + − +
© JRBirge MSOM INSEAD, July 2013 15
0( ) ( )[ ( )] ( )
0f q pqf q q
D cx≤ ≤
Joint Decision Making in an Imperfect Market
12
Interactive Effects between Production d Fi i l D i iand Financial Decisions
Separate operational and financial decision making is sub-optimal Production decision is negatively related with the production cost Debt decision is positively related with the production cost Optimal production decision is a decreasing function of financial leverage
1000
1200
0.8
0.9
atioProduction Level
Leverage Ratio
Optimal production decision is a decreasing function of financial leverage
800
1000
Out
put L
evel
0.6
0.7
t Lev
erag
e RaLeverage Ratio
400
600
0.4 0.5 0.6 0.7 0.8 0.9
O
0.4
0.5
Mar
ket
Production Cost
13
The Effects of Decision MisspecificationpKey Observations: Firm’s value is a convex function of financial leverage The effect of over-leverage is more severe than under-leverage Low-margin companies especially exposed to mis-
specifying decisions
The effect of production decision misspecification is moresevere
Production Misspecification
1e
Leverage Ratio Misspecification
e
0.6
0.8
1
aliz
ed F
irm V
alue
c: 0.6
c: 0 7
0.9
0.95
1
aliz
ed F
irm V
alue
c: 0.6
c: 0.7
0.2
0.4
0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5
Production Level
Nor
ma c: 0.7
c: 0.80.8
0.85
0 0.2 0.4 0.6 0.8 1
Leverage Ratio
Nor
ma
c: 0.8
14
Production Margin and Capital StructureTradeoff-Theory
An lower profit margin results in higher leverage (Fama & French 2002)
Model results
Leverage ratio is convex and U-shaped in production cost
Empirical ResultsEmpirical Results
For very high margin, leverage ratio appear to increase
60%
80%
100%
rage
Rat
io
Book Leverage Ratio
Market Leverage Ratio
0.3
0.4
0.5
aver
age
Rat
io
0%
20%
40%
0 0.2 0.4 0.6 0.8
P d ti C t
Leve
r
0.1
0.2
75% 80% 85% 90% 95% 100%O
Mar
ket L
a
Production Cost
15
Pre-tax Operating Margin
Additional Empirical EvidenceAdditional Empirical Evidence(JRB 2011)
• With fixed costs in this model leverageWith fixed costs in this model, leverage should first increase and then decrease in operating marginoperating margin
• Leverage/Operating Margin:
© JRBirge MSOM INSEAD, July 2013 20
Implications for the Supply ChainImplications for the Supply Chain (Yang/JRB 2011)
• Trade credit provides a risk-sharing mechanism p gbetween firms
• By borrowing from a supplier, a buyer inducesBy borrowing from a supplier, a buyer induces the supplier to share in the risk
• Chain coordination can then be enhanced• Chain coordination can then be enhanced• Policies should favor junior credit • Empirical evidence:
– Firms use trade credit then short-term when needed– Making suppliers senior seems to hurt trade credit
© JRBirge MSOM INSEAD, July 2013 21
Summary ObservationsSummary Observations• Operational decisions should be consistent with
financial realities• Operational and financial decisions are inter-
dependent in practical marketsdependent in practical markets • Inter-dependencies extend throughout the
supply chainsupply chain• Operational analyses (particularly the role of
it t) l i b d b h icommitment) can explain observed behavior and guide policy
• Much more research is needed at this interface © JRBirge MSOM INSEAD, July 2013 22
Thank you to MSOM!Thank you to MSOM!
© JRBirge MSOM INSEAD, July 2013 23
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