Debt and Product Market Fragility
AbstractThis paper studies the interplay between corporate leverage and product pricing when liquidation is costly for 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. There is a "good'' equilibrium in which the firm is in good financial shape. However, when leverage is excessive there is also "bad'' equilibrium in which consumers' pessimistic perceptions about the firm's financial health become self-fulfilling. Moreover, whenever the "bad'' equilibrium exists the "good'' equilibrium is highly fragile in that a small shock can trigger a spiral of sales drops. I show that the firm can avoid the "bad'' equilibrium by not fully exercising market power (i.e. cutting prices) and reducing leverage. The model sheds light on why highly leveraged companies often face severe sales drops and how price cuts and debt restructurings can help to restore customer confidence.
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Bibliographic InfoPaper provided by Université de Lausanne, Faculté des HEC, DEEP in its series Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) with number 00.21.
Length: 22 pages
Date of creation: Jul 2000
Date of revision:
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Fax: ++41 21 692.33.05
Web page: http://www.hec.unil.ch/deep/publications/cahiers/series
More information through EDIRC
debt; liquidation costs; business policy and financing decisions; market fragility;
Other versions of this item:
- Stefan Arping, 2000. "Debt and Product Market Fragility," Econometric Society World Congress 2000 Contributed Papers 1227, Econometric Society.
- 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
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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