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Debt and Product Market Fragility

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  • Stefan Arping

    (Universite de Lausanne)

Abstract

Liquidation 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 Info

Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1227.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1227

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  1. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  2. Kovenock, Dan & Phillips, Gordon M, 1997. "Capital Structure and Product Market Behavior: An Examination of Plant Exit and Investment Decisions," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 767-803.
  3. Opler, Tim C & Titman, Sheridan, 1994. " Financial Distress and Corporate Performance," Journal of Finance, American Finance Association, vol. 49(3), pages 1015-40, July.
  4. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," NBER Working Papers 5907, National Bureau of Economic Research, Inc.
  5. Gilson, Stuart C., 1989. "Management turnover and financial distress," Journal of Financial Economics, Elsevier, vol. 25(2), pages 241-262, December.
  6. 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.
  7. Matutes, Carmen & Vives, Xavier, 1996. "Competition for Deposits, Fragility, and Insurance," Journal of Financial Intermediation, Elsevier, vol. 5(2), pages 184-216, April.
  8. Chevalier, Judith A, 1995. "Capital Structure and Product-Market Competition: Empirical Evidence from the Supermarket Industry," American Economic Review, American Economic Association, vol. 85(3), pages 415-35, June.
  9. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  10. Phillips, Gordon M., 1995. "Increased debt and industry product markets An empirical analysis," Journal of Financial Economics, Elsevier, vol. 37(2), pages 189-238, February.
  11. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  12. Titman, Sheridan & Wessels, Roberto, 1988. " The Determinants of Capital Structure Choice," Journal of Finance, American Finance Association, vol. 43(1), pages 1-19, March.
  13. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  14. Hendel, Igal, 1996. "Competition under Financial Distress," Journal of Industrial Economics, Wiley Blackwell, vol. 44(3), pages 309-24, September.
  15. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262200716, January.
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Cited by:
  1. Purnanandam, Amiyatosh, 2008. "Financial distress and corporate risk management: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 87(3), pages 706-739, March.

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