Trade Credit in Supply Chains: Multiple Creditors and Priority Rules

We investigate the inventory stocking and capital structure decisions of a firm in the presence of an asset-based credit limit and costly bankruptcy. The key aspect of the paper is that we model the simultaneous decisions of an equity investor, the manager of the firm, and a bank. The investor decides how much to invest in the equity of the firm. The firm, a newsvendor, takes the investor’s decision as starting equity and decides its borrowing amount and order quantity in order to maximize the total return to the investor. The bank has partial information about the firm’s demand, and sets an asset based credit limit in order to prevent the firm from overborrowing. Our model builds on the literature in operations and corporate finance to determine the order quantity, capital structure, and probability of bankruptcy of the firm that would be realized at equilibrium in the marketplace. In particular, it shows how the probability of bankruptcy depends on the parameters of the newsvendor model and on information asymmetry between the firm and the bank. It also shows the role of the credit limit in determining the optimal capital structure regardless of the presence of taxation and bankruptcy costs.