Operational Investment and Capital Structure Under Asset-Based Lending

Problem definition: Banks commonly use asset-based lending (ABL) to provide loans collateralized by a borrower firm's inventory. We study the implications of ABL by examining how banks should determine asset-based loan terms based on firms' operational characteristics (e.g., inventory salvage value and demand uncertainty) and how firms should make inventory stocking and capital structure decisions under asset-based borrowing constraints. Academic/practical relevance: Despite its widespread use for lending to small firms and those with large inventory investments, such as retailers, ABL has not been well studied in the literature. Methodology: We analyze ABL using a stylized single-period screening game of incomplete information between a business owner and a bank. The bank offers a menu of loans, where each loan offer is characterized by an interest rate and inventory advance rate. The owner then decides the inventory level and the mix of debt and equity with which to finance the firm's operations. Our model captures the practical features of ABL, for example, the bank does not have the full knowledge of the firm's demand prospects, and the inventory advance rate leads to a credit limit that increases in the firm's inventory investment. Results: We show that ABL enables the bank to mitigate information asymmetry by screening firms and thereby controlling each firm type's order quantity and leverage. We also obtain hypotheses describing the equilibrium loan contracts, capital structure, inventory investment, and bankruptcy outcomes. For instance, leverage leads to overinvestment resulting from the equity decision being endogenous to the model. Moreover, inventory advance rates are more sensitive to firms' operational characteristics than interest rates. Managerial implications: Our study sheds light on the operational and financial implications of ABL by demonstrating how managers should make inventory and capital structure decisions while interacting with asset-based lenders.