Capital budgeting for volume flexible equipment

Capital budgeting for volume flexible equipment

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Article ID: iaor20083524
Country: United States
Volume: 27
Issue: 2
Start Page Number: 157
End Page Number: 184
Publication Date: Mar 1996
Journal: Decision Sciences
Authors:
Keywords: budgeting
Abstract:

Recent advances in technology have created opportunities for firms to invest in expensive automated equipment designed to improve volume flexibility. Such investments are made on the basis that flexibility benefits the firm by increasing managerial control over output, reducing the risk of demand uncertainty, and improving productivity. The presumption is that these benefits will eventually translate to higher cash flows, appreciation in the firm's market value, and better return to shareholders. Yet, there is no managerially useful analytical framework for measuring this relationship. This study develops a model that uses contingent claims analysis to evaluate the effect of volume flexibility on the firm's value and to determine the optimal degree of automation that maximizes share value. The analysis is done by taking into consideration alternative demand characteristics, cost patterns, and the effectiveness of volume flexibility in increasing managerial control over output, reducing the risk of demand uncertainty, and improving productivity.

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