Financial Leverage, Product Quality Failures, and Product Market Effects: Evidence from Product Recalls

Abstract

We study the impact of financial leverage on severe product quality failures that result in product recalls. Using a variety of tests, including two quasi-natural experiments that result in exogenous negative cash flow shocks to firms, we find that firms with higher financial leverage or likelihood of distress have a greater probability of a product recall. This is consistent with the view that these firms face investment distortions, either due to financial constraints or debt overhang, which adversely affect product quality. Further tests indicate that financial constraints, more so than debt overhang, have a greater economic impact in explaining the quality-leverage relation. Consistent with the view that taking on high debt relative to rivals makes the firm a weaker competitor, we find that recalling firms with high relative leverage experience more negative wealth effects to recalls while their industry rivals experience more positive wealth effects. These effects are, however, confined to the sub-sample of recalls in oligopolistic industries, where strategic interactions between firms are more likely. Key suppliers’ losses are exacerbated when they have more leverage or have committed larger relationship-specific investments. Overall, our paper highlights the effect of leverage not only on product quality at the firm level, but also on the broader product market effects of product quality failures.