Debt Financing and Supply Chain Capacity Investment

This paper studies a supply chain composed of a supplier and a buyer. The supplier has to make a buyer-specific capacity investment before demand uncertainty has been resolved. After the uncertainty has been revealed, the firms decide whether to trade with each other and on what terms through bilateral bargaining. I show that the supplier will borrow risky debt and invest more in capacity than if it Ire purely equity financed. The expanded capacity under risky borrowing is below the channel-efficient level if it is optimal to finance capacity investment with a mixture of equity and debt, and above the channel-efficient level if it is optimal to finance capacity investment entirely with debt.