Dr. P.V. Viswanath



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Capital Structure and Competitiveness

P.V. Viswanath, 2013

Product Market Competition:

How can debt be used to convince competitors that the firm will increase output in a price war?  When aggregate demand for a product is highly uncertain, higher output generally increases risk because it leads to higher profits when product demand turns out to be high, but lower profits when demand turns out to be low.  Since higher leverage increases a firm’s appetite for risk, the greater a firm’s leverage, the greater its incentive to produce at a higher level of output.  Not wishing to drive the price down to where no firm profits, competitors will accommodate the firms’ high output by producing at a lower level.

Note that these issues only arise in oligopolistic markets.  In oligopoly, since we have a few firms, it is not possible for a firm to ignore what its competitor(s) will do; hence any notion of equilibrium in an oligopoly has to take competitors actions into account.  (See Pindyck and Rubinfeld, Microeconomics, 6th edition.)

However, we also know that debt financing can lead firms to reduce their level of investment.  This can make the firm act less aggressively.  See, for example, the case in the next slide where the firm is close to bankruptcy, and the presence of debt causes the firm to act less aggressively.  This is the debt overhang problem, which also inhibits further borrowing for new investment.  Hence a leveraged firm may not exhibit all forms of aggressiveness.  In particular, aggressive behavior that requires additional investment may not be optimal for such firms. 

“(F)irms with greater access to external financing can threaten their rivals with lender-financed product market overinvestment.  Facing this threat, those rivals may accommodate. Therefore, consistent with the previous evidence on firms implementing leveraged recapitalizations, debt can initially provide for a product market advantage for those firms with greater access to credit.  However, in a world in which parties can renegotiate contracts, debt taking cannot support aggressive market strategies after a certain threshold.”  Lenders will not provide funding for high production strategies that are not sustainable by cost or other advantages.  From a strategic point of view, debt can provide at least limited and perhaps temporary strategic advantages against competitors.  (See Campello, 2006.)

If firms take on a lot of debt (perhaps because of a leveraged buyout or other exogenous event), managers become more concerned with short-term profits and the likelihood of bankruptcy.  In price sensitive industries, this leads to price cutting, in order to boost short-term cashflow (as in Phillips’ study of the Gypsum industry).  (This assumes that managers are able to extract value from the firm in the short run; if this is not possible, then manager will try to pay off debt and reduce leverage.).  However, if the industry is not very price-sensitive, the firm might try to raise prices and reduce output (as in Chevalier’s study of supermarkets).  The decision that is taken depends also on whether other firms are highly leveraged or not; if they are not highly leveraged, then they might react aggressively and this strategy might not work whereas if they are, they might follow suit and also increase prices (again, cf. Chevalier).

It is important to note the reason for the increase in leverage.  If it’s because of a leveraged buyout, then this is probably a short-term non-strategic move.  Hence it makes sense for managers to try and undo the debt increase as quickly as possible (or if managers can extract value, to increase short-term profits, as above).  However, if the increase in leverage is for strategic reasons, then the above conclusions are probably not appropriate.

We have seen that, all other things being the same, firms with increased leverage might want to increase their exposure to product market risk.  In industries where production decisions have to be made ahead of time (Cournot industries), this argument might lead leveraged firms to increase capacity.   Increased capacity would mean that if demand is high, profits will be high, but if demand is low, profits will be low, thus increasing volatility of profits.  However, this only works if competitors are accommodating. In Cournot industries (where competition is in strategic substitutes -- see below), this is likely to be so. But this is not true in all industry structures.

However, if the firm has to depend on continuing access to the debt market, e.g. if it has debt that is coming due soon, it might act in a myopic manner in order to be able to make these required payments without needing to subject itself to having to sell underpriced debt/equity because of debt overhang.  Once again, this depends crucially on whether we are talking about Cournot industries or Bertrand industries.  In Bertrand industries, this may lead to higher prices and, in Cournot industries, to higher output (assuming that price elasticity is not very high).  But if price elasticity is high, then the price-increase strategy in a Bertrand industry will not necessarily make sense because increasing prices may, well, decrease revenue.  Furthermore, even in a Bertrand industry, if the competing firm has enough financial resources (e.g. if it is not highly leveraged), it can cut its prices and steal market share.  Hence the result is: a) when a firm increases leverage following an exogenous event (such as a takeover), prices rise.  However, if it has unlevered rivals, prices can drop.  (See Dasgupta and Titman, 1998.)

In other words, we need to consider several factors:

  • one, is the industry a Cournot industry or a Bertrand industry;
  • two, is the price elasticity of demand high or low;
  • three, do managers have a high degree of non-diversifiable human capital invested in the firm;
  • four, does the firm need to access capital markets or to pay off debt in the near future;
  • five, is the leverage increase an exogenous event or part of a strategic move?

We can summarize some of the statements above as follows:

  • If it's a Cournot industry, then increased debt might lead to increased risk-taking and increased profits. If it's a Bertrand industry, this strategy might not lead to higher profits. However, if such aggression requires increased investment, all bets are off.
  • Increased debt might lead to higher profits, but it has to be backed by cost advantages, else in a multi-period world, the higher profits may not be sustainable.
  • Empirically, if higher debt is forced upon the firm (perhaps because of a leveraged buyout), the resulting aggression may not lead to strategic advantages, especially if competitors are not accommodating; if so, then the best strategy is to reduce the debt as soon as possible.


  1. What’s Cournot competition? 
    In a Cournot model, each firm takes the output of its competitors as fixed when deciding how much to produce.  Output is decided up front, then production follows the output decision; price is then set by the market to equate demand and supply.  Hence price is relatively flexible.  The outcome of a Cournot-Nash equilibrium is that output is less than in a perfect competition model and price is higher.
  2. What’s Bertrand competition? 
    In a Bertrand model, price is set up front; competition is on the basis of price.  Output then follows as a consequence of the price competition.  In this case, we obtain the perfect competition outcome; profits are zero and output is equal to the perfect competition amount. 
    If firms have to choose capacities upfront, then even if competition is Bertrand, the outcome is the same as that of a Cournot-Nash equilibrium, which makes sense because even if competition is Bertrand, firms cannot adjust output.
  3. How can we distinguish Bertrand industries from Cournot industries? 
    It is often said that in Cournot competition, there is price flexibility, whereas in Bertrand competition, there is output flexibility.
    Jong et al. use a measure they call CSM to distinguish between Cournot and Bertrand industries.  CSM is the correlation between the change in a firm’s profit margin and the change in the competitors’ output.  Sundaram et al. (1996) show that, in their model where they look at R&D investment, if CSM is smaller than zero, the industry is Cournot (competition is in strategic substitutes, i.e. if one firm reduces output, the others will increase output), whereas is CSM is greater than zero, the industry is Bertrand (competition is in strategic complements; if one firm raises prices, so do the others).  Effectively if aggressive action on the part of one firm is met by less agressive action on the part of the rest of the industry, then we say that competition occurs in strategic substitutes and the firm is Cournot.

    In a Cournot industry, if a firm tries to increase profits by reduced output, its competitors will increase output.  Hence the correlation between profit margin and competitors’ output will be positive; the reverse for Bertrand firms.
    Sundaram et al. find that the aerospace industry is reliably Bertrand; other likely Bertrand industries are personal care, leisure products and telecommunications.  On the other hand, the chemicals and pharmaceuticals industries are reliably Cournot.  Other likely Cournot industries are semi-conductors, medical products, food and computers.
    It is difficult to generalize from this list, but Bertrand industries seem to be ones where capacity can be relatively easily changed, whereas this is not the case generally with Cournot industries, e.g chemcials and pharmaceuticals.  Aerospace seems to be a special case, but this may be due to the presence of government-financed companies (Airbus).

Fresard, Laurent. “Financial Strength and Product Market Behavior: The Real Effects of Corporate Cash Holdings,” J of Finance, 2010
Campello, Murillo. “Debt financing: Does it boost or hurt firm performance in product markets?” JFE 2006
Dasgupta and Titman, 1998. “Pricing Strategy and Financial Policy,” The Review of Financial Studies,” Vol. 11, no. 4, Winter, pp. 705-737.

Advertising Competition:

Grullon et a. (2006) distinguish between two effects -- a) the effect of capital, in general, and b) the effect of debt capital. They find that firms that have raise significant amounts of capital do, in fact, step up the intensity of their advertising competition against industry rivals. However, the sub-sample of firms whose financial leverage has decreased as a result of the new funding competes _more_ vigorously than the sub-sample of firms whose leverage has increased. Furthermore, other firms respond to the greater advertising competition of the capital-raising firms in their industries by increasing their own advertising more aggressively than their industry peers if their own capital structure is relatively less levered than that of their industry peers. Thus, both in the initial effect of firms with lower leverage and in the resulting effect of competitors in that industry, it seems that lower leverage is more conducive to greater aggressiveness in advertising competition.

The authors speculate that firms with higher leverage are less aggressive in their advertising because higher leverage implies higher probability of going out of business and a consequent loss of the longer-term value of advertising. While this is possible, one could also argue that the causality here is reversed -- firms with higher intangible assets are likely to use less debt because intangible assets are more difficult to access/sell in case of bankruptcy. More likely (or at least another possibility) is that firms with more debt tend to be more myopic (see Grinblatt and Titman, 2nd edition, p. 567) because debt that needs to be repaid demands refinancing which, in turn, benefits existing debtholders more than equityholders (the underinvestment problem). To avoid this problem, firms go in for short-term projects which reduce the need to go back to the marketplace for new financing -- and certain kinds of advertising, at least, is a long-term investment. The debt overhang problem could also increase the required rate of return on new projects (so that equityholders get a sufficiently high return over and above the return that is captured by existing bondholders) and this reduces the firm's aggressiveness. Grullon et al. simply look at the total amount of advertising expenses; hence they cannot distinguish between these two interpretations of the behavior of the firms in their sample.

Theoretically, firms with higher leverage are more risk-seeking because of the option-like nature of levered equity; hence these two effects compete with each other. If new financing is required for the advertising strategy, the effect of leverage is likely to be less agression, while otherwise the risk-seeking behavior might predominate.


Grullon, Kanatas and Kumar (2006) "The Impact of Capital Structure on Advertising Competition," Working Paper, Rice University.
Grinblatt, Mark and Sheridan Titman


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