17.3Capital Structure and Competitive Strategy

Having explored how a firm’s interactions with its customers, suppliers, employees, and the

government affect its financing, we now introduce another player into our analysis: the

firm’s competitors. This section describes how leverage can affect the competitiveness of

an industry and how this in turn is taken into account by firms selecting their leverage ratios.

Chapter 16 discussed how leverage affects a firm’s incentives to take on risky proj-

ects and to liquidate its business. If these investment and exit decisions influence the

actions of a firm’s competitors, then the firm’s leverage choice may be a strategic tool

that allows it to achieve a competitive advantage.

To understand the strategic role of the capital structure choice, it is necessary to

understand the importance of a firm’s ability to commit to a strategy that it might later

want to change. An excellent example of this is a market leader’s commitment to main-

tain an 80 percent market share. Carrying out such a commitment would be costly if

one of its competitors chose to contest the market leader and capture a larger share of

the market for itself. In this case, a price war is likely to result, creating losses for the

market leader and its competitor.

Acompetitor that believes the market leader will fight to keep its market share will

be reluctant to aggressively expand its own market share. Hence, the market leader can

capture a strategic advantage if it credibly commits to protecting its market share

aggressively. However, the competitor may not believe that the market leader’s com-

mitment is credible and may believe instead that, faced with an aggressive competitor,

the market leader will acquiesce and give up market share rather than struggle through

a costly price war. As we discuss below, a firm’s capital structure choice can play an

important role in determining how these strategic issues evolve.

Does Debt Make Firms More or Less Aggressive Competitors?

Firms can sometimes benefit from debt if high debt ratios allow them to commit to an

aggressive output policy that they otherwise would not be able to carry out.¹³For

example, a firm may wish to send a message to its competitors that it plans to increase

its production. If the competitors ignore this message, the added production is likely to

reduce the price of the output and, thus, reduce profits to both the firm and its com-

petitors. However, if the message is credible, the competitor may accommodate the firm

by reducing its output instead of engaging in a price war. In this case, the aggressive

policy does increase the firm’s profits.

How does a high debt ratio help a firm send a credible message that will convince

competitors that it will indeed increase output? To understand this, first note that when

aggregate demand for a product is highly uncertain, higher output generally increases

risk. Higher output increases risk because it leads to higher profits when product

demand turns out to be high, but lower profits when demand turns out to be low. Hence,

since higher leverage increases a firm’s appetite for risk (see the discussion of the asset

substitution problem in Chapter 16), the greater a firm’s leverage, the greater its incen-

tive to produce at a high level of output. Competitors, observing a firm’s high lever-

age ratio, will realize that the firm is going to produce at a high level. Not wishing to

drive the price down to the point where no firm profits, the competitors may accom-

modate the firm’s high output by producing at a lower level.

13

See Brander and Lewis (1986) and Maksimovic (1986).

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Will debt always make a firm act more aggressively? Recall from Chapter 16 that

debt financing can lead firms to reduce their level of investment, which can make them

act less aggressively. Consider, for example, a firm that can increase its market share

by either lowering its price or increasing its advertising. The firm is likely to suffer

reduced profits in the short run by carrying out either strategy, but it should realize

greater profits in the long run from gaining a higher market share. Gaining market share

with either of these approaches is thus an investment that becomes more or less attrac-

tive as the relevant discount rate increases or decreases. As we discussed in Chapter 16,

because of the debt overhang problem, more highly levered firms use higher discount

rates to evaluate investments. This implies that they will compete less aggressively to

increase their market share.¹⁴

Example 17.5 illustrates how a firm’s capital structure choice can affect a firm’s

borrowing costs and thereby affect its incentive to price aggressively to obtain greater

market share.

Example 17.5:Highland’s Pricing Choice

Highland, a small supermarket chain in the Midwest, is considering lowering prices in one

of its markets to attract more customers.Their managers have estimated that the firm will

initially make less money from the lower price strategy, since it reduces their margins on

existing customers and it will take a while before they attract new customers.Within a

year, however, they will have attracted enough new customers so that their cash flows

will be higher than they were prior to the price reduction.

Although Highland’s total cash flows are quite risky, its director of marketing believes the

incremental cash flows associated with a more aggressive pricing strategy can be estimated

with virtual certainty.Based on this assumption, he has made the following projections:

Year 1 Cash FlowsYear 2 Cash Flows

Low price strategy	$100,000	$147,000
High price strategy	$120,000	$125,000

Highland’s assistant treasurer is asked to give his opinion of the strategies under two sce-

narios.Under the first scenario, the differencesin the cash flows between the low and high

price strategies, being risk free, are evaluated given the firm’s current borrowing rate of 8

percent, which corresponds to the risk-free rate.He is also asked to consider how the strat-

egy would be affected under a second scenario in which the firm has substantially more

debt, and thus must pay an interest rate of 12 percent on additional debt.Will the change

in leverage affect his recommendation?

Answer:First, calculate the difference between the low and the high price cash flows:

Year 1 Difference	Year 2 Difference
$20,000	$22,000

¹⁴This

argument is based on models developed by Chevalier and Scharfstein (1996) and Dasgupta and

Titman (1998).

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Hence, the low price strategy is a positive NPVinvestment as long as its cash flows are

discounted at a rate that is less than 10 percent.If the strategy is evaluated by discounting

the cash flows to the equity holders, the low price strategy is an attractive strategy when the

firm has a low leverage ratio and an 8 percent borrowing rate butnot if it has a highlever-

age ratio and a 12 percent borrowing rate.

The preceding example illustrates how increased debt can make firms less

aggressive competitors. However, as we discussed above, there are other situations

where increased debt can make firms more aggressive. We summarize this discus-

sion as follows:

Result 17.3

Leverage affects the competitive dynamics of an industry. In some situations, leveragemakes firms more aggressive competitors, in others less aggressive.

Eastern Airlines Revisited

When Eastern Airlines went bankrupt, other airlines expressed concern about Eastern's

aggressive pricing strategy. To fill vacant seats, Eastern cut fares. Other airlines felt obliged

to at least partially match this fare cutting, resulting in substantially lower profits for East-

ern and its competitors. In response to the “disruption in pricing” brought about by bank-

rupt airlines, executives at major airlines aggressively lobbied Congress to change the bank-

ruptcy laws that allowed bankrupt airlines to continue operating.

Our analysis of stakeholder costs along with the incentive distortions created by highly

leveraged firms provides some insights into the issues raised by airline bankruptcies. Recall,

for example, the discussion regarding passenger concerns about the quality of service on a

bankrupt airline. Because of these concerns, a bankrupt or financially distressed airline would

have to charge significantly lower prices to attract customers than a financially healthy air-

line could charge. The executives of healthy airlines claim that they were forced to match

those price cuts, which probably was not completely true, because most passengers prefer

healthy airlines even if their prices are somewhat higher. Nevertheless, the pricing behavior

of the bankrupt airlines probably did contribute to the downward pressure on prices, and we

agree with those executives who called for a faster resolution of airline bankruptcies.

The discussion in Chapter 16 explained why the managers of a bankrupt airline had an

incentive to keep the airline operating as long as possible. Neither equity holders nor man-

agement has an incentive to shut down a financially distressed airline because the proceeds

of a liquidation would go almost entirely to the firm's debt holders, particularly the most

senior creditors. In addition, the airlines would have an incentive to keep prices low to

increase the number of seats they fill for each flight because it would be difficult to justify

to the bankruptcy judge that the airline should remain in operation if the planes were fly-

ing with most of their seats empty.

Debt and Predation

Afirm’s leverage ratio will also affect the strategies of its competitors. Specifically, a

highly leveraged firm might be especially vulnerable to predationfrom more conser-

vatively financed competitors.¹⁵In other words, a competitor might purposely lower its

prices in an attempt to drive the highly leveraged firm out of business. This could be

to the competitor’s advantage in the long run if doing so bankrupts its more highly

leveraged rival—forcing it to exit the market.

¹⁵Bolton

and Scharfstein (1990) consider a model where a less leveraged firm prices aggressively to

drive a more leveraged firm from the market.

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The predatory policy of the conservatively financed firm is especially effective in

industries where customers and other stakeholders are concerned about the long-term

viability of the firms with which they do business. For example, a producer of

specialized computer equipment might be driven from the market more easily by an

aggressive competitor than a producer of a breakfast cereal. If the computer equipment

producer’s customers believe that the firm is likely to go bankrupt and might not be

able to service its products, these customers will stop purchasing the products, making

the belief self-fulfilling. It would be much more difficult to scare off the customers of

a company making breakfast cereal, so predatory pricing to force out highly leveraged

firms in this industry is likely to be less effective.

Empirical Studies of the Relationship between Debt Financing and Market Share

Although some theoretical arguments suggest that highly leveraged firms can become

more aggressive, leading them to increase market share, the empirical evidence more

strongly supports the idea that high leverage tends to generate losses in market share.

For example, Opler and Titman (1994) found that highly leveraged firms lose market

share to their more conservatively financed rivals during industry downturns, when high

leverage is likely to lead to financial distress.

There are at least three reasons for why high debt ratios might cause firms to lose

market share:

1.The financially distressed firm faces debt overhang and, as a result, may invest

less, be forced to sell off assets, and reduce its selling efforts in other ways.

2.Because of concerns about its long-term viability and the quality of its

products, a highly leveraged firm may find it difficult to retain and attract

customers.

3.Rivals may view a highly leveraged firm as a less formidable competitor and

seize the opportunity to steal its customers and perhaps eliminate it.

Evidence on Why Distressed Firms Lose Market Share.There is evidence to sup-

port all three of these reasons. First, distressed firms tend to sell off assets and cut back

on their level of investment.¹⁶Second, the more highly leveraged firms with high R&D

expenditures have the greatest tendency to lose market share during industry down-

turns.¹⁷High R&D firms tend to produce more specialized products, and as a result,

their customers are more concerned about their long-term viability. Hence, the corre-

lation between R&D expenditures and the tendency of highly leveraged firms to lose

market share supports the stakeholder theory.

There is also evidence to suggest that the third reason is relevant. For example,

Opler and Titman (1994) found that the tendency of highly leveraged firms to lose mar-

ket share during industry downturns is related to the number of competitors in the

industry. In industries with few competitors, the highly leveraged firms lose the most

market share, which supports the idea that a firm with a significant market share will

attract predators when it is financially weakened. In the more competitive industries,

individual firms have fairly small market shares and do not present such inviting tar-

gets when they are financially distressed.

16

See studies by Asquith, Gertner, and Scharfstein (1994) and Lang, Poulsen, and Stulz (1995).

¹⁷See

Opler and Titman (1994).

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Changes in Market Share Following Substantial Leverage Increases.Although

modest amounts of debt probably affect competition only during industry downturns,

extremely large increases in debt can have an almost immediate effect. To explore this

possibility, Phillips (1995) and Chevalier (1995a, b) examined how large capital struc-

ture changes affect the competitive dynamics of an industry. Phillips examined four dif-

ferent industries in which one or more of the largest firms substantially increased its

leverage. In three of the four industries, the leverage increase led to corresponding

decreases in industry output and increases in prices. In these cases, the industries

became less competitive. In the fourth case, the leverage increase resulted in greater

industry output and lower prices.

Chevalier examined in great detail one industry, retail supermarkets, a particularly

interesting industry to study for two reasons. First, a number of supermarket chains ini-

tiated leveraged buyouts (LBOs) in the 1980s, substantially increasing their leverage,

while others remained conservatively financed. In addition, the widespread use of elec-

tronic checkout scanners has made data for individual product prices at individual stores

readily available. The study of the entry, exit, and expansion behavior of supermarket

chains in 85 metropolitan areas [Chevalier (1995a)] demonstrated that rival firms are

more likely to enter and expand in a local market if a large share of the incumbent

firms have undertaken LBOs. In other words, highly leveraged stores are viewed as

less formidable competitive rivals.

In her other study, Chevalier (1995b) found that supermarket prices tend torise in

cities in which the dominant firm or firms restructure in ways that substantially increase

their leverage. This increase, however, is substantially mitigated and perhaps reversed

in cities that include a relatively large rival with a large market share. In addition, she

finds that in the 1990s, subsequent to the restructurings, the firms that increased lever-

age tended to charge higherprices. This evidence supports the idea that increased lever-

age makes firms less aggressive competitors, but in some situations, an increase in

leverage also can make a firm’s competitors more aggressive.

Other interesting industry studies include Zingales’s (1998) study of the trucking

industry after deregulation and Khanna and Tice’s (2000) study of how discount depart-

ment stores responded to the expansion of Wal-Mart into their markets. Zingales found

that in the sector of the trucking industry where service is more important, the more

highly leveraged firms tended to charge lower prices and were less likely to survive.

This evidence is consistent with the idea that customers are reluctant to do business

with a firm that could potentially be financially distressed. The Khanna and Tice study

found that leverage made department stores that were owned by large publicly traded

firms less aggressive in their response to Wal-Mart. In addition, the publicly held

department stores responded more aggressively than the privately owned stores, and

stores owned by public firms with more inside ownership responded less aggressively.¹⁸