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Strategic Debt in Vertical Relationships

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  • Gianni De Fraja
  • Claudio A. G. Piga

Abstract

We study a vertical relationship between two firms, and we show that the extent of the downstream firm's borrowing affects the contract offered by the upstream firm. We establish a negative relationship between the level of debt and the downstream firm's probability of bankrupt. We also show that, unless the interest rate is very high, there exists a conflict of interest between the upstream and the downstream firm: the latter wants to take on more debt than the former would like it to.We interpret this finding as an explanation of the constraint imposed by franchisors on the debt level of their franchisees.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 98/16.

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Handle: RePEc:yor:yorken:98/16

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Keywords: Contract Theory; Capital Structure; Franchise;

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  1. 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.
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  6. Demsetz, Harold & Lehn, Kenneth, 1985. "The Structure of Corporate Ownership: Causes and Consequences," Journal of Political Economy, University of Chicago Press, vol. 93(6), pages 1155-77, December.
  7. 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.
  8. 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.
  9. Léonard,Daniel & Long,Ngo van, 1992. "Optimal Control Theory and Static Optimization in Economics," Cambridge Books, Cambridge University Press, number 9780521337465.
  10. Holmstrom, Bengt R. & Tirole, Jean, 1989. "The theory of the firm," Handbook of Industrial Organization, in: R. Schmalensee & R. Willig (ed.), Handbook of Industrial Organization, edition 1, volume 1, chapter 2, pages 61-133 Elsevier.
  11. Mathewson, G Frank & Winter, Ralph A, 1985. "The Economics of Franchise Contracts," Journal of Law and Economics, University of Chicago Press, vol. 28(3), pages 503-26, October.
  12. Rajiv Lal, 1990. "Improving Channel Coordination Through Franchising," Marketing Science, INFORMS, vol. 9(4), pages 299-318.
  13. Showalter, Dean M, 1995. "Oligopoly and Financial Structure: Comment," American Economic Review, American Economic Association, vol. 85(3), pages 647-53, June.
  14. James A. Brander & Tracy R. Lewis, 1988. "Bankruptcy Costs and the Theory of Oligopoly," Canadian Journal of Economics, Canadian Economics Association, vol. 21(2), pages 221-43, May.
  15. Brander, James A & Spencer, Barbara J, 1989. "Moral Hazard and Limited Liability: Implications for the Theory of the Firm," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(4), pages 833-49, November.
  16. Friend, Irwin & Lang, Larry H P, 1988. " An Empirical Test of the Impact of Managerial Self-interest on Corporate Capital Structure," Journal of Finance, American Finance Association, vol. 43(2), pages 271-81, June.
  17. 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.
  18. Marsh, Paul, 1982. " The Choice between Equity and Debt: An Empirical Study," Journal of Finance, American Finance Association, vol. 37(1), pages 121-44, March.
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Cited by:
  1. Gianfranco Atzeni & Claudio Piga, 2005. "R&D investment, Credit Rationing and Sample Selection," Discussion Paper Series 2005_6, Department of Economics, Loughborough University, revised Jun 2005.
  2. Antonio Acconcia & Riccardo Martina & Salvatore Piccolo, 2005. "Vertical Restraints under Asymmetric Information: On the Role of Participation Constraints," CSEF Working Papers 141, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 01 Jan 2007.

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