Operational Investment and Capital Structure Under Asset-Based Lending

Abstract

We analyze a single-period game of incomplete information between a business owner and a bank to study the relationship between operational investment and capital structure in the context of asset-based lending (ABL). The bank moves first and offers a menu of loans to maximize its expected profit. Each loan offer is characterized by an interest rate and an inventory advance rate, which gives a credit limit that is increasing in the firm’s inventory investment. The owner then decides the inventory level and the mix of debt and equity with which to finance her firm’s operations. Our paper results in several new insights into the optimal solution for the firm, the characteristics of the menu of loan terms offered by the bank, and the sensitivity of the loan terms and equilibrium outcomes with respect to the operational characteristics of the firm. For instance, a leveraged firm stocks more inventory regardless of the interest rate or credit limit. These insights can be tested with data in future research.