Chapter 27 Financial structure and product market competition

Abstract

Publisher Summary This chapter focuses on four mechanisms that are identified in the literature as determining how financial structure affects value in product markets. These mechanisms are (1) the effect of investment choices of other firms in the industry on the interaction between the firm's financial structure and its investment incentives, (2) the effect of debt on a firm's ability to enter into advantageous implicit and explicit contracts with competitors or customers, (3) the effects of changes in leverage firms' incentives and on industry equilibrium in oligopolies,and (4) the exploitation by competitors of conflicts of interest caused by the firm's need to finance its investments externally. The industry equilibrium (IE) models are presented that directly extend the single firm paradigm by analyzing financial structure choice in the context of an industry equilibrium that takes into account the investment decisions of all firms in the industry. To discuss how financial structure affects the firm's ability to make credible implicit or explicit contracts with customers and rival firms, the chapter presents an analysis of two consequences of leverage. First, high debt levels increase the probability that the firm will become bankrupt and cannot be compelled to fulfil its obligations. Second, debt may decrease both the profits that the firm's equityholders receive from complying with the contract and the cost that they bear if they act opportunistically. Both these effects decrease the firm's ability to enter into credible contracts.