Sunk Investment, Bargaining and Choice of Capital Structure

This paper shows how a firm might optimally choose debt to affect the outcome of bilateral bargaining with workers or other input suppliers. It is shown that debt may alleviate the well known underinvestment problem associated with the inability to write precommitment contracts. Also, in such circumstances, debt could be Pareto improving over complete equity financing. The relationship between the optimal level of debt and asset specificity of investment and bargaining power of the firm vis-a-vis the workers is explored. The Williamson conjecture that higher asset specificity will lead to less debt is shown not to be valid in general.