Does Debt Make Firms Weak Competitors? Evidence Using U.S. Stock Returns

Abstract

Prior studies examine real firm behavior and show that high debt makes a firm vulnerable in the product market. In this study, we assess the economic magnitude of competitive effects of debt by examining stock returns. For identification, we use a double-layer of contrasts by conditioning our tests across the business cycle and varying product differentiation environments. Firms with high relative-to-industry debt experience significantly lower stock returns during recessions but similar returns during normal times compared to firms with low relative-to-industry debt. The results are driven by the sub-sample of firms with low product differentiation where the competitive effects of debt should be the strongest. Returns are 9% lower during recessions for firms with above industry median debt in this sub-sample. This finding is robust to alternative explanations such as endogeneity, mechanical leverage effects, business risk, debt overhang, and customer warranty concerns. We also link real effects to stock returns by showing that debt-induced sales growth is a significant determinant of stock returns. Our finding that the competitive effects of debt have an economically significant effect on stock returns is important to investment bankers who advise firms on capital structure decisions, chief financial officers, corporate treasurers, and equity money managers.