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Review of Quantitative Finance and Accounting

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01.02.2014 | Original Research

Outsourcing with long term contracts: capital structure and product market competition effects

verfasst von: João C. A. Teixeira

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 2/2014

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Abstract

This paper analyzes how capital structure and product market competition affect the firms’ strategic choice between outsourcing with long term contracts and outsourcing to the spot market. When outsourcing to the spot market firms are exposed to price uncertainty, whereas a long term contract allows them to set in advance the outsourcing price. We show that, to the extent that leverage and uncertainty can lead to financial distress costs in bad states of nature, firms may use long term contracts as a risk management device to hedge input price uncertainty. With a monopoly in the final product market, the outsourcing decision involves a trade-off between a positive convexity effect of input price uncertainty under the spot regime and the option to avoid financial distress costs under the long term contract regime. Moreover, product market competition among buyers can lead to an increase in financial distress costs not only for firms outsourcing to the spot market but also for firms outsourcing with a long term contract. We examine the monopolist’s outsourcing decision and derive the equilibrium for an oligopoly, and show that the equilibrium depends on the magnitude of these costs and on the level of efficiency of the supplier.

Vorheriger Artikel Optimal portfolio choice of gold assets in the differential market and differential game structures

Nächster Artikel The implied intra-day probability of informed trading

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For a survey on the forces driving international outsourcing see Spencer (2005). Kuo and Wang (2005) provide empirical report that during the 1997 Asian financial crisis multinational firms, especially in the IT industry, have substantially used international outsourcing in order to cut costs. Also, Lambrecht et al. (2012) develop a model where they show how firm adjust the outsourcing strategy to the economic cycle.

Of course, there are a number of other motivations for hedging, including taxes, managerial incentives, capital market imperfections and inefficient investment. For a review of the determinants of hedging by corporations see Smith and Stulz (1985) and Froot et al. (1993).

This positive convexity effect derives from Jensen’s inequality. Since the expected profit is a convex function of input price uncertainty, it follows that the expected value of a convex function of a random variable is greater than the value of the function evaluated at the expected value of the random variable.

Grossman and Helpman (2002), Levy (2006) and Fontenay and Gans (2008) develop an outsourcing model that incorporates a bilateral game between a buyer and a set of suppliers but where the proportion of the surplus collected by each part is exogenous.

The analysis is motivated by the findings of Kleindorfer and Wu (2003) and Spinler et al. (2003). They argue that, in many industries, the supplier can offer an outsourcing price lower than the expected spot price because a long term contract allows the supplier to plan in advance, lowering cost staffing, maintenance and other production costs.

In our model, debt has an impact in the number of firms in equilibrium as it can induce positive financial distress costs and consequently change the incentives for the choice of the equilibrium regime.

The parameter k has an upper bound (see expression in the “Appendix”) to ensure that the monopolist’s equity value remains positive. Formally, we require that the expression for the firm’s profit, net of financial distress costs, as given by (5), is positive.

The expression for the set of parameters for which \( FDC_{S}^{\text{u}} \ge 0 \) is presented in Proposition 1.

As noted earlier, this positive convexity effect derives from Jensen’s inequality.

When the condition for positive financial distress costs (11) is satisfied, we show that financial distress costs depend positively on s as \( \frac{{\partial FDC_{S}^{u} }}{\partial s} = k\frac{{\alpha_{A} - \left( {c_{A} + m + s} \right)}}{2} > 0 \).

The game in is modeled as in Fan and Sundaresan (2000). In order to focus on the role of financial distress on the outsourcing decision, we ignore repeated interactions between the buyer and the supplier (see Dawid and Kopel 2003 and Hadlock and Lewis 2003 for a dynamic model of bargaining in subcontracting).

This is the maximum profit the parties can make together if negotiation is possible, where they act jointly as a global optimizer.

The optimization problem is solved only for the relevant case where the monopolist’s outside option is lower than the total profit under global maximization, i.e. \( E\left( {\Uppi_{AS} } \right) \le {{\Uppi}}_{GM} \).

Note, however, that there is an upper bound for \( s_{1}^{*} \) as it has to ensure positive input prices (\( 0 < s_{j}^{*} < m \)) and positive quantities in the bad state of nature \( \left( {0 < s_{j}^{*} < \frac{{\alpha_{A} - \beta_{A} \left( {c_{A} + m} \right)}}{{\beta_{A} }}} \right) \). See proof of Proposition 4 for this derivation.

The set of input parameters used is as follows: monopolist’s bargaining power \( \eta = 0.5 \), expected spot price \( m = 20 \), marginal cost of the supplier \( c_{B} = 20 \), size of market A \( \alpha_{A} = 70 \), slope of demand function \( \beta_{A} = 1 \), marginal cost of monopolist \( c_{A} = 20 \), fixed cost of monopolist \( f_{A} = 0 \), debt \( D = 200 \) and intensity of financial distress costs parameter \( k = 0.8 \). In the example it follows that only \( s_{1}^{*} \) exists.

Remember that, if we assume no cost difference between the two regimes (in expected terms, i.e. \( m = c_{B} = p_{BLT} \)), then in the good state (d), firms that outsource to the spot market are more competitive than firms outsourcing with a long term contract as they buy the input B at a lower price. In this state the input price in the spot market is \( p_{B}^{d} = m - s \), whereas with the long term contract it is \( m = p_{BLT} > p_{B}^{d} \). This cost disadvantage of firms outsourcing with a long term contract may induce these firms to incur financial distress costs. For example, an increase in the number of firms outsourcing to the spot market (more efficient firms in this state) can lead to a decrease in downstream prices, and as a consequence to a depression in the profits of firms outsourcing with the long term contract.

Note that the assumption of \( \eta = 1 \) implies that the expected profit under global maximization is equal to the profit each buyer expects from outsourcing with a long term contract, i.e. \( E\left( {\pi_{GM} } \right) = E\left( {\pi_{ALT} } \right) \).

The expressions for the equilibrium quantities and for the realized profits in each state of nature when financial distress costs are zero, \( \pi_{AS\,NFDC}^{i} \) and \( \pi_{ALT\,NFDC}^{i} \), are presented in the “Appendix”.

The expressions for the set of parameters that ensure zero financial distress costs are presented in the “Appendix”.

The figure is generated using the following parameter values: \( m = c_{B} = 20 \), \( \alpha_{A} = 120 \), \( \beta_{A} = 1 \), \( c_{A} = 20 \), \( f_{A} = 0 \), \( s = 6 \), \( k = 5 \), \( n = 12 \), and \( D = 0 \).

Once again, the expressions for the set of parameters that ensure positive financial distress costs are presented in the “Appendix”.

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Titel: Outsourcing with long term contracts: capital structure and product market competition effects
verfasst von: João C. A. Teixeira
Publikationsdatum: 01.02.2014
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 2/2014
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-013-0344-1

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