Lead-time Reduction, Capital Structure and Optimal Investment Policies

We consider a manufacturing firm that sells a seasonal product to a market with uncertain demand. The firm determines the production quantity each period in the face of demand uncertainty. Lead-time reduction allows the firm to postpone its decision about the production quantity until partial or full resolution of demand uncertainty, thereby reducing the exposure to supply-demand mismatches. This reduces financial distress costs and hence increases the market value of debt. We analyze the value of lead-time reduction under financial constraints and also the impact of lead-time reduction on the optimal capital structure. We model the evolution of demand forecasts using the multiplicative martingale process and provide an expression of the expected firm profit as a function of lead time. We numerically show that firms with more restricted working capital levels tend to underestimate the value of lead-time reduction. We then derive closed-form expressions that quantify the impact of lead time on firm value, the optimal leverage ratio, and the cost of capital. We show that firms can significantly increase their market value by using external funds and capitalizing on the value of lead-time reduction.