Double marginalization because of external financing: Capacity investment under uncertainty

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.