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Unformatted text preview: cuss is whether debt makes firms more or less aggressive competitors in product markets
11 Capital Structure & Competitive Strategy High debt ratios may allow firms to commit to an aggressive policy that they otherwise would not carry out
Suppose a firm wants to send the message that it will expand its production
It competitors ignore the message, excess supply will reduce prices and profits for all firms
If competitors take the message seriously, they may accommodate by reducing their production instead of engaging in a price war
In this case the aggressive firm can increase its profits 12 Capital Structure & Competitive Strategy How can debt commit a firm to produce a higher output?
Consider an industry with highly uncertain demand, where firms produce before they know demand
Higher output increases risk: if demand is high (low) the firm will make large profits (losses)
Now consider a highly leveraged firm that needs to generate high profits to avoid default. Such firm will have a strong incentive to take large risks and will indeed produce a high output
Competitors will accommodate by reducing production 13 14 Capital Structure & Competitive Strategy High debt ratios may commit a firm to act less aggressively Example: debt financing can reduce a firm’s investment. Why? Higher interest payments reduce a firm’s ability to retain earnings and forces it to seek external finance for expansion
Financing from retained earnings is often cheaper than outside finance due to informational asymmetry or agency problems Thus, high debt is a commitment to a high cost of external finance and costly output expansion
Rival firms may also behave less aggressively and do not try to make up all of the decreased output from the leveraged firm 15 Capital Structure & Competitive Strategy A highly leveraged firm might be vulnerable to predation from low
In words, a competitor might choose to lower its prices to drive the highly leveraged firm out of business
If the highly leveraged firm exits the market, the competitor steals its market share and increases profits
Predation is easier when customers or other stakeholders are concerned with the longterm viability of the firm (e.g., a producer of specialized computer equipment 16 Capital Structure & Competitive Strategy To summarize, financial leverage definitely affects the competitive dynamics of an industry
In some situations, leverage makes firms more aggressive competitors in product markets. This leads to higher output and lower pric...
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This document was uploaded on 03/09/2014 for the course COMM 371 at The University of British Columbia.
- Spring '13