UNDERINVESTMENT, DEBT FINANCING, AND LONG-TERM SUPPLIER RELATIONS

Prior studies have documented that in firm-supplier relations where th e firm makes an investment up-front, the profits are exposed to exprop riation by the supplier and result 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 surplu s generated by the investment. In this scenario, debt financing is adv antageous to the firm since it shields some wealth away from the suppl ier. We also demonstrate that allowing the firm to issue debt and reti re equity subsequent to the investment decision mitigates the underinv estment problem. This result obtains even when the debtholders are for ced to participate in the negotiations. However, this efficiency prope rty of debt is lost if the investment is made by the supplier and not by the firm.