Financing Capacity Investment Under Demand Uncertainty: An Optimal Contracting Approach

We study the capacity choice problem of a firm whose access to capital is hampered by financial frictions (i.e., moral hazard). The firm optimizes both its capacity investment under demand uncertainty and its sourcing of funds from a competitive investor. Ours is the first study of this problem to adopt an optimal contracting approach: feasible sources of funds are derived endogenously from fundamentals and include standard financial claims (debt, equity, convertible debt, etc.). Thus, in contrast to most of the literature on financing capacity investments, our results are robust to a change of financial contract. We characterize the optimal capacity level under optimal financing. First, we find conditions under which a feasible financial contract exists that leads to the first-best capacity. When no such contract exists, we find that under optimal financing, the choice of capacity sometimes exceeds strictly the efficient level. Furthermore, the firm invests more when its cash is low, and in some cases less when the project's unit revenue is high. These results run counter to the newsvendor logic and standard finance arguments. We also show that our main results hold in the case of a strategic monopolist investor, and such an investor may invest more then a competitive one.