Abstract
This paper studies how a firm’s pricing strategy affects its financial leverage. Retailers vary in pricing strategy, ranging from low markup (i.e., “discount”), no frills retailers to high markup retailers that offer extensive service. The choice of strategy affects the firm’s risks and opportunities and therefore debt capacity. The high-end strategy, for example, exposes the firm to price wars and free-riding by discount rivals that could drive it into financial distress. The cross-section of firms shows a negative relationship between markup and leverage, but the direction of causality is unclear. To establish causality, I exploit changes in the legality of discount pricing strategies to identify their effect on leverage. In various U.S. states and years, manufacturers could use resale price maintenance (RPM) to set the minimum price a retailer can charge. I find that allowing RPM leads discount retailers to reduce leverage and other retailers to increase it. The results show that firms choose a financial structure closely tied to their product market strategy.
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