Risk Sharing Supplier Relationships and Investment Financing Decisions

Abstract

This paper investigates the effects of risk sharing supplier relationships on the profitability and cost of capital of a new investment project. We compare the three possibilities of not investing in the project, bearing the project risk alone and sharing the risk with a supplier. We find that firms enter risk sharing contracts with a supplier if there is a mismatch between the capital available and the capital needed for financing a new investment opportunity. A low leverage ratio on the supplier's side abets the profitability of risk sharing - making a low debt ratio a competitive advantage for the supplier. Moreover, we show that the equity cost of capital for the project can decrease especially for high risk and highly pro table projects.

Keywords: supplier relationships, risk sharing contract, investment financing, cost of capital, optimal capital structure