Debt and Product Market Fragility
AbstractLiquidation of a supplier of durable goods can be costly for its customers because it frequently undermines the smooth supply of after-sales service and spare parts or makes it more costly. This paper studies the interplay between capital structure and product pricing strategy when liquidation imposes costs on customers. I develop a model which illustrates that highly leveraged firms can enter a vicious circle in which financial distress and sales drops are re-enforcing. Multiple equilibria can arise. There exists a "good" equilibrium in which consumers buy and the firm is in good financial shape. However, when agency problems between investors and managers are severe, there is also "bad" equilibrium: consumers turn away from the vendor, the market collapses, and the firm goes bankrupt. Moreover, the "good" equilibrium is highly fragile in that a small shock to the firm's profits can trigger a spiral of sales drops. I show that the firm can avoid the "bad" equilibrium by cutting prices and reducing leverage.
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Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1227.
Date of creation: 01 Aug 2000
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Other versions of this item:
- Stefan ARPING, 2000. "Debt and Product Market Fragility," Cahiers de Recherches Economiques du DÃ©partement d'EconomÃ©trie et d'Economie politique (DEEP) 00.21, Université de Lausanne, Faculté des HEC, DEEP.
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
- L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance
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