Double Marginalization Because of External Financing: Capacity Investment Under Uncertainty

Abstract

This paper considers a firm’s investment decision determining the timing and capacity level in a dynamic setting with demand uncertainty. Its investment is financed by borrowing from a lender that has market power, generating a capital market inefficiency. We show that the firm’s investment is subject to double marginalization in the sense that the need for external financing results in a considerably smaller investment and thus, a reduction in welfare. In addition, we find that the presence of the bankruptcy option mitigates the double-marginalization effect unless the bankruptcy cost is small. The firm’s investment size is increasing in bankruptcy costs, albeit at the expense of an investment delay. Based on this, an increase of bankruptcy costs raises social welfare. This paper was accepted by Tomasz Piskorski, finance. Funding: X. Wen and H. Dawid gratefully acknowledge support from the Deutsche Forschungsgemeinschaft [Grant SFB 1283/2 2021–317210226]. The authors acknowledge financial support from the Center of Interdisciplinary Research at Bielefeld University [Research Group “Economic and Legal Challenges in the Advent of Smart Products”]. K. J. M. Huisman is appointed to a special chair at Tilburg University that is funded by ASML. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2023.01152 .