Underinvestment, Debt Financing, and Long-term Supplier Relations

Prior studies have documented that in firm-supplier relations where the firm makes an investment up-front, the profits are exposed to expropriation by the supplier, and results in underinvestment. We analyze such a firm-supplier relation in a bargaining framework, and show that the bargaining power of the firm is positively related to the resale value of its investment, and negatively related to the product market surplus generated by the investment. In this scenario, debt financing is advantageous to the firm since it shields some wealth away from the supplier. We also demonstrate that allowing the firm to issue debt and retire equity subsequent to the investment decision mitigates the underinvestment problem. This result obtains even when the debtholders are forced to participate in the negotiations. However, this efficiency property of debt is lost if the investment is made by the supplier and not by the firm.