Strategic Debt in Vertical Relationships
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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