Downstream Firm's Equity Financing for Capacity Expansion in a Supply Chain

In this research, we investigate a supply chain consisting of a downstream firm who purchasesa component from an upstream firm, and then transforms it into a final product. The downstreamfirm has a production capacity constraint and considers to raise capital from an investor throughequity financing. The raised capital not only enables the downstream firm to expand the capacity,but also allows the investor to hold equity shares in the downstream firm. In detail, we considertwo equity financing models: in the external equity financing model, the capital is raised froman outside institution; while in the internal equity financing model, the capital is raised fromthe upstream firm. We derive the optimal pricing decisions of the two firms, and discuss theoptimal equity financing strategy. Because the cooperative relationship between the two firmscan be improved in the internal equity financing model, the production quantity in this modelmay be even higher than that in a benchmark model with no capacity constraint and no equityshares held by the investor in the downstream firm. Moreover, although the original shareholderof the downstream firm always has a chance to benefit from the two types of equity financing, itis more advantageous to raise capital from the upstream firm. We also analyze the impacts of thekey parameters on the financing strategy, and find that the dependence of the financing strategyon the initial asset of the downstream firm in the two models are quite different. Numericalstudies show that less capital raised for expanding capacity may create more value for the originalshareholder of the downstream firm when the production cost of the downstream firm is changed