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Debt and Product Market Fragility

  • Stefan Arping

    (Universite de Lausanne)

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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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. 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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  13. 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.
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