Capital structure and supply chain capacity investment

This paper studies whether risky borrowing will induce a supplier to expand capacity and thus mitigate a capacity underinvestment problem in supply chains. It demonstrates that the relationship between capacity and capital structure is not as simple as the existing literature suggests. If the supplier is very powerful, it will use a mixed capital structure and build less capacity than if it were equity financed. If the buyer is very powerful, the supplier will use all debt financing and overbuild capacity. In this case, the supplier would not agree to build capacity ex ante if it were prohibited from borrowing. Hence, borrowing is Pareto optimal. Under a more balanced power structure, the supplier may choose all debt financing and overbuild capacity or all equity financing and underbuild capacity, depending on the trade‐off of the bargaining benefits and costs of debt financing.