Unformatted text preview: ts product and fairness to employees and suppliers depends on its financial condition
A firm’s financial condition affects how it is perceived in terms of being a reliable supplier, customer, and employer
Financial distress is especially costly for firms with:
– Products with quality that is important yet unobservable
– Products that require servicing
– Employees and suppliers who require specific investments
These firms should hold less debt 7 Benefits of Distress With Committed
Stakeholders High debt / financial distress may provide a firm with an advantage in negotiation with committed stakeholders
Bargaining with labor unions: by increasing leverage a firm can reduce wages by exploiting employee’s fear that higher wages may push the firm into bankruptcy
Bargaining with suppliers: similar story, in particular for specialized suppliers
Bargaining with the government: a government is likely to help a firm whose demise would cause “spillover effects” on local economies (e.g., Chrysler in Michigan)
8 Capital Structure & Competitive Strategy How does a firm’s financial policy affect the behavior of its rivals?
Main issue: leverage can affect the competitiveness of an industry and this will be taken into account by firms selecting their leverage ratios
Leverage may serve as a strategic tool that allows a firm to achieve a competitive advantage
The main reason is that leverage may serve as a commitment device: A firm may want to find ways to commit to a strategy that it might later want to change. 9 Capital Structure & Competitive Strategy Example: A market leader states it will maintain an 80% market share
If a competitor tries to capture a larger market share for itself, and the leader defends its position, the resulting price war creates losses for both the leader and its competitor
A competitor who believes that the leader will indeed fight to keep its market share will be reluctant to expand
A competitor who believes that the leader in fact will give up some market share to avoid a costly price war will likely choose to expand 10 Capital Structure & Competitive Strategy Thus, the leader wants to look tough, that is, to commit to retaliate if some rival attempts to steal its market share
If this commitment is credible in the sense that the leader will indeed retaliate, then rivals will not attempt to expand
Can debt serve as a commitment device?
The main issue we want to dis...
View Full Document