Title: Franchise Contracting with Debt Financing and Bankruptcy Risk
We focus on the role of financing and dynamics in franchise contracting. We solve a sequential-moves game with three players: the franchisor, the entrepreneur, and the banks. The franchisor chooses values of contract terms (a one-time franchise fee and a royalty rate). The entrepreneur dynamically decides when to sign this contract and open a store, applying for debt financing to cover the initial investment. In response to the entrepreneur’s application, banks (perfectly competitive) determine loan rates. Thus, we solve an optimization problem over the franchise contract terms, which affects the solution of the optimal stopping time problem of the entrepreneur (the threshold for opening a store), which is subject to financial market equilibrium constraints. We find that the franchisor should use royalty cash flows and not franchise fee to extracts value from the entrepreneur. To account for the possibility of the entrepreneur’s bankruptcy and bankruptcy costs, the franchisor should decrease royalty rate. However, despite lower rate, the threshold for the entrepreneur to open the store is higher in the model with financing than in the model without financing. This threshold is much higher than it would have been for the integrated system, which in turn is higher than the static break-even NPV threshold. If a franchisor ignores financing considerations, she will suffer having to wait longer for a store opening and from a higher entrepreneur's bankruptcy probability. The franchisor is the main beneficiary of the entrepreneur's greater initial wealth. Finally, the franchisor will benefit if she can assume a greater share of the store’s operating costs.
Song Alex Yang
Title: The Supply Chain Effects of Bankruptcy
Bankruptcy and the following reorganization process play an important role in the competitiveness and profitability of not only the firm facing bankruptcy risk, but also its competitors and suppliers. Conversely, supply chain interactions can significantly influence a distressed firm's probability of bankruptcy and reorganization. Using a supply chain consisting of two downstream firms, one being financially distressed, and their common supplier, this paper captures this mutual influence between supply chain interactions and bankruptcy risk using three supply chain effects of bankruptcy: the predation effect, the bail-out effect, and the abetment effect. Reflecting that the competitor benefits from the distressed firm's bankruptcy, the predation effect intensifies pre-bankruptcy competition. This effect creates a competitive advantage for the non-distressed firm when the supplier cannot control price, yet makes one firm's bankruptcy a positive externality for a supplier with pricing power. The bail-out effect suggests that the supplier grants concessions to the distressed firm both before and after bankruptcy. This effect balances the power between the supplier and the distressed firm and improves supply chain efficiency. The efficiency is further enhanced when the supplier and the distressed buyer are financially linked, justifying the exclusivity rule in Chapter 11. However, this effect may transform one firm's bankruptcy into a negative externality to its competitor. The abetment effect reveals that the supplier may facilitate the competitor's predation and leads to a pre-bankruptcy operational disadvantage for the distressed firm, providing an explanation why some companies only bail out a major buyer after the latter goes bankrupt, not before. Finally, we show that restricting the supplier to uniform pricing strengthens the predation effect, and hence actually benefits the supplier in the cost of consumers, justifying the current trend of abandoning the Robinson-Patman Act.
Title: Analysis and Enhancement of Practice-based Policies for the Real Option Management of Commodity Storage Assets
The real option management of commodity storage assets is an important practical problem. Practitioners heuristically solve the resulting stochastic optimization model using the rolling intrinsic (RI) and rolling basket of spread options (RSO) policies. Combined with Monte Carlo simulation, these policies typically yield near optimal lower bound estimates on the value of storage. This paper provides novel structural and numerical support for the use of the RI and RSO policies, and enhances them by developing a simple and effective dual upper bound to be used in conjunction with these policies. Moreover, this work emphasizes the superiority of the RI policy over the RSO policy and proposes a variant of the RSO policy that, on the considered instances, slightly improves on the average performance of the RSO policy but yields a more substantial improvement when the suboptimality of this policy is more pronounced.
Title: Capacity Management for Oilseeds Processors
This paper studies the capacity investment decisions of a processor (an oilseed pressing plant) that uses a commodity input (oilseed) to produce a commodity output (crude vegetable oil) and a byproduct in proportions. The oilseed and the crude vegetable oil are traded in the spot markets. We model the processor’s decisions in a multi-period framework. At the beginning of the planning horizon, the processing capacity for the input and the storage capacity for the output are chosen. In each period, given these capacity levels, the processing volume for the input and the storage volume for the output are chosen with respect to the input and the output spot price uncertainties as well as the production yield uncertainty. We demonstrate that, in general, the optimal capacity investment portfolio is not balanced, i.e. the proportional input-output relationship does not hold for this optimal portfolio, and we explain why. Focusing on the palm industry, our analysis provides some rules of thumb for the capacity management: The processor should decrease its capacity investment portfolio with an increase in spot price correlation; and with an increase (decrease) in the input or the output spot price variability when this variability is sufficiently lower (higher) than the other variability. To investigate the impact of using heuristic capacity investment policies (such as ignoring the production yield uncertainty or by-product) on profitability, we conduct computational experiments using a calibration based on a palm oil mill. These experiments use data from Malaysian Palm Oil Board, complemented by the industry supply and demand studies based on Southeast Asia. These experiments demonstrate that these heuristic capacity investment policies lead to significant losses in profit.
Title: Global Sourcing under Exchange-Rate Uncertainty
We consider a firm’s capacity reservation and sourcing decisions in sourcing under exchange rate and demand uncertainty. The firm initially reserves capacity from one domestic and one international supplier in the presence of exchange rate and demand uncertainty. After observing exchange rates, the firm determines what capacity to utilize for manufacturing, but this decision is still made under demand uncertainty. We identify the set of optimal solutions, and the conditions that lead to onshore sourcing, offshore sourcing, and dual sourcing. Our analyses lead to three main findings. First, we identify that, while demand uncertainty by itself does not lead to dual sourcing, exchange-rate uncertainty is one of the main reasons a firm would engage in global dual sourcing. Second, lower unit capacity and unit manufacturing costs are neither a necessity nor a sufficient condition to reserve capacity at a supplier. Our study shows that the firm can reserve capacity at a supplier even if it has higher capacity reservation and manufacturing costs. Third, global dual sourcing decisions can be characterized in two classes. One dual sourcing policy is based on rationing limited capacity in order to minimize the negative consequences of exchange-rate fluctuations. The second dual sourcing policy features extra capacity investment and is intended to benefit from the flexibility to alter the production decisions from one supplier to another based on fluctuating exchange rates.
Title: The Midas Touch: An Empirical Investigation of Gold Hedging
This paper empirically examines the relationship between hedging and firm variables. Specifically, we leverage a database compiled from the gold mining context to examine the effects of gold hedging on firm inventory and profit variance. Our unique database offers two important advantages. First, we are able to capture the exact amount of gold in ounces hedged by a company. This is in stark contrast to the majority of empirical studies examining hedging, which measure hedging from a coarse, binary perspective. Secondly, prior empirical research has studied company hedging policies using cross-sectional models. We use quarterly hedging data from 2006 to 2011 to examine the effects of hedging from a longitudinal lens. Our results indicate that there is a significant relationship between hedging and operational performance. Specifically, we observe that companies which hedge more gold tend to hold less inventory. Additionally, we find that hedging gold results in an increase in future profit variance. These results afford preliminary empirical support for insights from analytical studies found in Operations literature.
Title: The Influence of Financial Risk on Inventory Control Decisions
The essence of inventory control to find the optimal balance between setup-cost and holding cost on one end (the order-quantity problem) and between holding cost and shortage cost given on the other (the safety-stock problem). Traditionally these operational decisions, as other operation decisions, have been made without any direct consideration of their financial implications and vice versa. Earlier research has shown that the affect of ignoring this link can lead to significant increases in cost. In particular, it has been shown that the financial risk associated with a stochastic purchase price has a large influence on the capital cost of holding inventory and the resulting optimal inventory policy. The financial risk associated with a stochastic demand matters, as well, but the ramification of not adjusting the policy due to this risk is limited. These are only two of the parameters that do influence the optimal policy though and the aim of this work is to see if there are other parameters, such as the set-up cost, shortage cost, lead-time, etc., where the financial risk does matter.
Title: The Entrepreneurial Newsvendor: Managing Market Frictions through Process Investment
Existing literature considers process R&D investment decisions, especially for entrepreneurial firms, in isolation of capital market frictions. Such frictions increase the cost of raising funds. We setup a two period problem where a capital constrained entrepreneur can make a preemptive process investment in the first stage. In the second stage, this entrepreneur borrows to facilitate production in anticipation of demand. At this stage the borrowing cost is conditioned by the preemptive investment decision. Our results show that the preemptive investment decision can be employed as an operational hedge to mitigate capital market frictions and create value by enhancing the firm’s financing options and production volume. The fiscal value created by mitigating frictions is in addition to the traditional benefits (e.g. reducing the risk associated with matching of demand and supply) of process investment. We derive conditions when such a preemptive investment is the optimal for the entrepreneur in the presence of capital market frictions. Finally, in order to establish the relevant operating policy, we derive an expression for critical fractile for production that accounts for capital market frictions.
Title: Supply Chain Network Structure and Risk Propagation
Supply chain relationships have a significant impact on firm performance across the global network, but the effect of centrality and multiplicity of relationships varies depending on the firm's level in the supply chain hierarchy. In particular, increasing centrality reduces upstream firms' exposure to systematic risk while it has the opposite effect for downstream firms. This talk will describe a three-level model of supply chain interactions which captures these empirical observations.
Title: Systematic Risk and Mass Layoffs: Evidence from the U.S. Manufacturing Sector
We study the role of systematic risk in jobs relocation decisions of manufacturers. We use mass layoffs data in the U.S. manufacturing sector for the period from 2002 to 2010, and financial markets volatility as a proxy of systematic risk. We examine whether, after controlling for factors such as labor costs, transportation costs, exchange rates, contract workers, regulations, change in capital intensity, labor productivity etc., volatility in financial markets explains the layoffs. The research in this area has a number of important implications for policymakers as well as operations of capital markets in developed as well as developing countries.
Title: Agency Theory of Trade Credit
This paper provides a new motivation for the use of trade credit based on the agency theory. Debt financing results in the well-known agency conflict between the creditor and the firm’s shareholders who have the incentive to maximize the value of equity rather than total firm value. Because of the limited liability effect, maximizing the value of equity leads to risk seeking behavior known as the asset substitution problem. Trade credit can mitigate this problem because its terms are tied to the actual procurement decision and thereby prevent excessive risk taking. Whereas it is difficult for a firm to commit to value maximizing procurement decision when borrowing cash, buying on credit is in itself a commitment. We illustrate this benefit of trade credit in the context of a financially constrained retailer procuring inventory of two products under uncertain demand. When using bank financing, the retailer overinvests (underinvests) in the product with the lower (higher) salvage value, higher (lower) profit margin, or higher (lower) mean demand. In contrast, a retailer relying on trade credit has incentives to choose the first-best inventory levels, for which it is rewarded by a lower cost of borrowing.
Title: Operationalizing Financial Covenants
We identify and study a fundamental link between a firm's operations management and the design of financial covenants in secured (asset-based) lending contracts. While it is widely held that covenants serve to protect lenders and alleviate agency conflict, by restricting unwanted firm behavior, the ways in which a borrowing firm adapts, twists, and contorts its operations in response has not been studied. We characterize the market conditions and contract terms under which covenants are (not) optimal, and discuss how lenders can ‘’operationalize’’ financial covenants, i.e., think about their effectiveness, design, and implementation, in light of these considerations. In a monopolistic setting, we show a non-monotonic relationship between covenant ‘’tightness’’ and the firm's operational flexibility, specifically, its ability to adjust leverage (either through inventory investment or collateral liquidation).