Ex Post Production Flexibility, Asset Specificity, and Financial Structure

Abstract

This paper examines the interaction between the firm's production and financing decisions, focusing on the specificity of its assets and on the flexibility of its production technology. The paper shows that production flexibility increases potential tax shields from debt and lowers expected bankruptcy costs and that, when asset specificity is low, operating and financial leverage tend to be complements, with the complementarity becoming stronger as ex post capacity adjustment costs increase. It also shows that an increase in the corporate tax rate induces the firm to increase capacity investment and financial leverage when asset specificity is low and that this effect becomes stronger as ex post capacity adjustment costs increase. The results suggest that in industries where assets are easily redeployable, the impact of taxes on both investment and financial leverage will be positive and increasing with the size of capacity adjustment costs.