Economic Evaluation of Scale Dependent Technology Investments

We inquiry the effect of financial risk upon the economic evaluation of a throw with capacity decisions. Capacity decisions have an important event on the project's value from one side the up-front investment, the associated operating take away from and constraints on output. However, increased scale also affects the financial risk of the throw through its effect on the operating leverage of the investment. Although it has drawn out been recognized in the finance literature that operating leverage affects shoot forward risk, this result has not been incorporated in the operations management literature when evaluating projects

We close attention the decision problem of a firm that must prefer project scale. Future cash sweep along uncertainty is introduced by uncertain subsequent time market prices. The firm's capacity decision affects the firm's potential sales, its awaited price for output, and its require to be paid [i]or[/i] undergones We study the firm's profit maximizing scale decision using the CAPM archetype for risk adjustment.

Our springs include that project risk, as measured by dint of the required rate of get back is related to the inverse of the awaited profit per unit sold. We also display that project risk is related to the scale choice. In contrast, in traditional discounted cash stream analysis (DCF), a fixed prescribed rate is used to evaluate the throw and choose its scale. When a fixed rate is used with DCF a manager will ignore the event of scale on risk and prefer suboptimal capacity that reduces throw value. S/he will also misestimate cast value.

Use of DCF for choosing scale is studied for sum of two units special cases. It is shown that if the manager is directed to use a prescribed discount rate that induces the optimal scale decision, then the manager will greatly undervalue the shoot forward In contrast, if the discount rate is station to the risk of the optimally-scaled cast the manager will undersize the throw by a small amount, and slightly undervalue the cast with the economic impact of the error being small. These rises underline the importance of understanding the source of financial risk in shoot forwards where risk is endogenous to the shoot forward design.

Key words: capacity planning; cast risk; technology investments

Submissions and Acceptance: Received December 2003; revision received July 2004; accepted November 2004

1 Introduction

This paper studies by what means scale decisions affect the financial risk and therefore the value of a throw out For many years, finance scholars have recognized that require to be paid [i]or[/i] undergone structure affects the financial risk of a firm end its "operating leverage," which is defined as the ratio of variable profits (revenue minus variable costs) to operating profits (variable profits minus fixed operating costs) In markets where claims to these cash sweep alongs are traded, financial risk affects the riskiness of the firm's futurity cash flows and thus, the price investors are willing to pay for a claim to these cash runs Using finance valuation models, like as the Capital Asset Pricing prototype (CAPM), analytic results about the relationship between operating leverage and throw out risk, and thus firm value, have been derived. Although this approach has been used to value firmwide cash roll ons it is also possible to use it in capital budgeting words immediately preceding [i]or[/i] followings to value projects of firms whose stocks are traded upon financial markets.

However, use of financial risk adjustment prototypes that incorporate the risks associated with operating leverage have rarely been applied to valuing and designing operations shoot forwards A rare example of an operations paper that explores this issue is Lederer and Singhal (1988) In that paper, the authors exhibit that cost structure affects the risk of throws but do not address the issue of project choice on incomes In general, when scale (or other operations decisions that affect income or costs) changes, the repercussions include changes in the require to be paid [i]or[/i] undergone structure, the production volume, the operating leverage, the throw out cash flow, the riskiness of the throw and finally, present value of risk adjusted cash roll on If decisions are made that ignore the interaction of scale and risk, then cash sweep alongs are misvalued and suboptimal operations decisions are made.

The relationship between a firm's operating leverage and risk, as measured by the agency of CAPM's beta parameter, was analytically documented in Rubinstein (1973) Brenner and Schmidt (1978) and Gahlon and middle class (1982). Lev (1974) and Mandelker and Rhee (1984) empirically showed that operating leverage comput as the ratio of total firm contribution divided by means of total firm profit is directly related to firm risk, confirming these follows However, all of these studies limit use of this theory to exhibit total firm value is related to its risk [i]or[/i] part of to the other operating leverage, and do not apply this theory to throws and other firm investment decisions.

The interaction of scale and risk is usually ignored when using the greatest in quantity popular financial evaluation technique: discounted cash stream analysis (DCF). In DCF analysis, a fixed discount rate is typically applied to the cash roll ons Because this rate is usually not changed when scale changes, the result of scale on value is misestimated and generally, suboptimal scale decisions are made.