On the Cost of Capital in Inventory Models: The Case of Deterministic Demand

In the operations management literature, the financial risk in an inventory model is usually assumed to be captured by the (constant) weighted average cost of capital (WACC) of the firm. This assumption is, at best, an approximation, since this cost depends on the risk of the cash flows, which, in turn, depends on the inventory policy. This paper explores what the right cost of capital should be in an inventory model with deterministic demand. We find that, in contrast to other existing models, risk is not in general a monotone function of inventory. Also, a rate close to the risk-free rate, which typically deviates significantly from the WACC, should be used to value inventory-related investments when the inventory cost function is dominated by holding cost for large order quantities, even if investments are subject to other sources of financial variability.