This paper considers a firm’s investment decision within an uncertain framework, where the investment is financed by borrowing. The lender has market power, generating a capital market inefficiency. The investment decision involves determining the timing and the capacity level. The firm’s investment is subject to double marginalization in the sense that the lender’s market power results in a considerably smaller investment and therefore leads to a reduction in welfare. Introducing the bankruptcy option 34 reveals that the double marginalization effect is mitigated in a scenario with high bankruptcy cost and large enough demand uncertainty: the firm’s investment size is increasing in bankruptcy costs albeit at the expense of an investment delay. As a result, the bankruptcy option can increase (total) welfare.
(joint work with Herbert Dawid, Nick F.D. Huberts, Kuno J.M. Huisman, and Xingang Wen)