Agency Cost of Debt: A Case for Supplier Financing

Abstract

In this paper, we first show how debt financing distorts the inventory decision of a multi–product retail firm. Protected by limited liability, a debt–financed retailer seeks risk by favoring items with a low salvage value, those with a high profit margin, and those that represent a large share of the total inventory investment. Second, we demonstrate that in many cases, this distortion can be avoided by using supplier financing. A supplier who automatically observes the retailer’s order quantities, can deter risk–seeking behavior on the part of the retailer with the threat of stricter credit terms. This provides suppliers with a financing advantage over banks, which can monitor inventory only at a cost.