Adaptation to Shocks and The Role of Capital Structure: Danish Exporters During the Cartoon Crisis

How do firms’ responses to an unexpected demand shock vary with their capital structure? We study the boycott of Danish products in Muslim countries in response to a Danish newspaper publishing caricatures of prophet Muhammad. Using detailed firm data on financial statements, trade flows, product innovation, and outsourcing activities of Danish exporters, we exploit variation in their capital structure and exposure to Muslim countries to analyze the effect of leverage on their response to the boycott in input and output markets. We find that firms with low leverage compensate for lost demand by increasing investment, introducing new products and redirecting their sales elsewhere. In contrast, high leverage firms reduce sales, employment and investment and substitute employees with outsourcing and owning assets with leasing. This focus on short-term cost savings is consistent with indirect costs of financial distress borne away from bankruptcy in the form of constrained adjustment to changing demand.