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Optimal debt contracts and product market competition with exit and entry

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  • Khanna, Naveen
  • Schroder, Mark
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    Abstract

    We show how competition in oligopolies, with the possibility of failure and exit of a levered incumbent, affects the ex-ante design of optimal debt contracts. When a levered firm's profits are unobservable, a debt contract imposes the threat of nonrenewal to induce truthful revelation. Because nonrenewal impacts the future profitability of the surviving competitor, the contract influences the competitor's pricing strategy and the equilibrium profits of both firms. The optimal contract is quite different from a standard debt contract, and induces the competitor to be less aggressive, resulting in higher equilibrium prices and profits, and higher returns for investors.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Theory.

    Volume (Year): 145 (2010)
    Issue (Month): 1 (January)
    Pages: 156-188

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    Handle: RePEc:eee:jetheo:v:145:y:2010:i:1:p:156-188

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    Web page: http://www.elsevier.com/locate/inca/622869

    Related research

    Keywords: Contract theory Debt Asymmetric information Predation;

    References

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    8. Faure-Grimaud, Antoine, 2000. "Product market competition and optimal debt contracts: The limited liability effect revisited," European Economic Review, Elsevier, vol. 44(10), pages 1823-1840, December.
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    15. Khanna, Naveen & Tice, Sheri, 2005. "Pricing, exit, and location decisions of firms: Evidence on the role of debt and operating efficiency," Journal of Financial Economics, Elsevier, vol. 75(2), pages 397-427, February.
    16. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
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