Optimal capital structure with supplier market power

Abstract We use a real‐option model to study the effect of input supplier's market power on a firm's capital structure, and identify the Nash equilibrium outcome (firm's investment and financing policies and its supplier's pricing policy). When its supplier has market power, the firm will reduce leverage ratio and delay investment. This can help explain why observed leverage ratios are lower than in traditional capital‐structure models (without supplier market power). Firm value can be increased by the vertical acquisition of the supplier, which would also result in a higher leverage ratio. This helps explain the observed increase in leverage ratios after acquisitions.