Operational Investment and Capital Structure Under Asset-Based Lending

We study the implications of asset based lending for operational investment, probability of bankruptcy, and capital structure for a borrower firm. We set up a single-period game with two players, a business owner and a bank. The business owner decides how to allocate her capital between the equity of a new business and the external capital market in order to maximize her expected profit. We model the new business as a single-period inventory (newsvendor) model. The bank does not know the newsvendor’s demand distribution, and sets an asset based credit limit to maximize its expected profit. We show that the equilibrium order quantity is a function of market parameters, and deviates from the classical newsvendor solution. In this solution, asset based lending leads to an upper limit on the potential loss faced by the bank, and thus, helps manage bankruptcy risk. In particular, the collateral value of inventory is a function of the bank’s belief regarding the firm’s demand distribution because the amount of inventory that will have to be liquidated in case of a default is random and depends on the realized demand. This result contrasts with the common practice of banks to use simple rules of thumb to value inventory and set a credit limit. We also show that the probability of bankruptcy and the capital structure at equilibrium are functions of information asymmetry, bankruptcy costs, and the newsvendor model parameters. ∗Johnson Graduate School of Management, Cornell University, Sage Hall, Ithaca, NY 14853-6201, E-mail: ya47@cornell.edu, vg77@cornell.edu