Capital structure theories customarily are developed in a single-firm framework and disregard competition intensity among
firms in output markets. Theories implicitly assume that by choosing capital structure strategically, firms cannot enhance their
competitive positions in output markets. In addition, output markets are assumed to offer an exogenous random return
unaffected by firms' choices of capital structure. However, several studies such as
Titman (1984)
,
Brander and Lewis (1986)
, and
Maksimovic (1988)
examine the strategic choice of capital structure. These studies focus on the strategic role of debt, implying
that debt financing shifts output strategies of a firm's rivals in a way that benefits the firm.
1
Using strategic debt characteristics, a
firm can enhance its future competitive position in its industry. Alternatively, a debt equilibrium level is determined when
benefits equal the agency costs associated with its increase.
Choice of capital structure can affect future competitive position in the manner that
Brander and Lewis (1986)
refer to as the
limited liability effect of debt financing.
2
Because of this principle, managers (shareholders) need to only consider firms' returns
during profitable periods, as creditors claim all assets in receivership. In other words, debt financing elevates managers' incentives
to adopt riskier output strategies.
3
Hence, debt enhances competitive advantage by enabling firms to pre-commit to a more
aggressive output strategy. This suggests that firms can influence their competitive position by strategically using debt. As a
result, a firm's capital structure affects competitive interaction among firms in output markets.Although the theoretical literature extensively analyzes the relationships among output strategy, competitive position, and
capital structure, little empirical evidence confirms them. Among the empirical literature,
Phillips (1995)
and
Kovenock and
Philips (1997)
investigate the relationship between intra-industry price variation and a firm's capital structure.
Showalter (1995)
theoretically demonstrates the conclusion in
Brander and Lewis (1986)
that firms' strategic incentive to increase debt depends
both on the type of competitive interaction among firms in the output market and on the type of uncertainty the firm faces. Based
on his earlier theoretical findings (
Showalter, 1995
),
Showalter (1999)
verifies the relationship between uncertainty in output
markets and the strategic role of debt.
MacKay and Phillips (2005)
examine the relationship between a firm's capital structure and
industry position, defined as the similarity of its capital
–
labor ratio to its industry's median capital
–
labor ratio.
4
Lyandres (2006)
performs a broad cross-sectional analysis of the relationship between firms' capital structure and the extent of their competitive
interaction (whether competition is Cournot or Bertrand).
These prior studies hypothesize that firms will choose a capital structure that enhances their advantage in the output market if
debt financing presents a strategic advantage. Hence, these studies investigate relationship between capital structure and
intra-industry price variation, uncertainty, industry concentration, and competitive interaction in output market. However, these
analyses do not specifically reveal any strategic advantage offered by debt. This paper examines their unanswered question: How
does the strategic advantage of debt manifest itself in output markets?
We examine market share as the variable that reflects the strategic advantage of debt because it is an important indicator of
competitive position. A firm's objective in the output market is to improve its competitive position. If debt financing offers
strategic value, it manifests itself in terms of the firm's improved competitive position. Few previous empirical studies define
market share as the indicator of a firm's competitive position in its industry. For instance,
Frésard (2010)
empirically verifies
whether cash holdings have a strategic advantage that improves the competitive position and defines a firm's market share as
competitive position.
This paper assumes that a firm's capital structure influences its market share, and vice versa. This assumption originates in the
Brander and Lewis (1986)
that foresighted firms anticipate the consequences of their financial decisions on output markets; thus,
output market conditions influence financial decisions. Our empirical strategy is to verify the relationship between capital
structure and market share as an indicator of competitive position within the industry through simultaneous equations in which
both variables are endogenous.
Theoretical literature predicts that the nature of competitive interaction among firms affects the relationship between capital
structure and competitive position.
“
Nature of competitive interaction
”
refers to whether firms engage in Cournot (quantity) or
Bertrand (price) competition. Cournot competition corresponds to strategic substitution: a firm complaisantly accommodates a
competitor's strategic move. Bertrand competition corresponds to strategic complementarity: a firm escalates competition by
matching a competitor's move. If a firm's output strategy is Cournot (substitutional), its reaction function slopes downward, while
in the case of Bertrand (complementary), it slopes upward.
Based on this theoretical suggestion, we classify samples into Cournot or Bertrand competition and employ the Competitive
Strategy Measure (
CSM
) to distinguish them. This verifies hypotheses regarding the relationship between capital structure and
market share separately for Cournot and Bertrand firms. To this end, hypotheses to be verified are as follows.
Because of the principle of limited liability, increasing debt raises a firm's incentive to adopt a more aggressive strategy. Hence,
higher debt induces a Cournot firm to produce more and a Bertrand firm to reduce prices. How these actions affect a firm's market
share depends on how rivals react. In the Cournot framework, a rival reduces its output, because Cournot firms compete as
strategic substitutes. As a result, the leveraged Cournot firm's market share increases and the rival's market share decreases. In the
Bertrand framework, the rival is likely to reduce prices, because Bertrand firms compete as strategic complements. In this case,
the market share effects on leveraged Bertrand firms become ambiguous because this hypothesis assumes that competitors
simultaneously reduce prices. However, the overall impact on market share becomes clear if firms do not set prices
simultaneously, i.e., one is a Stackelberg price leader and the other the follower. The Stackelberg leader's share increases by
reducing prices ahead of rivals, because demand for its product increases.
We present testable hypothesis about what the effect of market share on a firm's leverage ratio. Due to the limited liability
effect of debt financing, a firm's equity holders have an incentive to prefer riskier output strategies. However, when providing
additional funds, debt holders accommodate this effect by requiring a risk premium that increases proportionately to the amount
of debt. Evidently a firm's market share increases through leverage; however, there is a simultaneous increase in the agency costs
of debt. Hence, lower market share firms seeking to expand their market share generally increase leverage because the strategic
benefits from debt outweigh the associated agency costs. However, agency costs exceed the debt benefits with an increase in
market share. Hence, the greater the firm's market share, the lower its leverage ratio.
5
This paper presents evidence for the following findings. Under Cournot competition (strategic substitutes), leverage affects
market share positively, implying that leveraged Cournot firms can boost their market share. Similarly under Bertrand
competition (strategic complements), leverage significantly and affirmatively affects market share, implying that Bertrand firms
can increase market share via debt financing. They have incentives to reduce prices ahead of rivals. Thus, Bertrand competition fits
the Stackelberg model.Market share affects leverage significantly and negatively regardless of whether firms compete as substitutes or complements,
implying that market share leaders restrict debt financing and restrain leverage to preserve competitive advantage if agency costs
outweigh the benefits of increased debt. Therefore, leverage is in equilibrium when the strategic benefits of debt equal the agency
costs associated with its increase.Our evidence supports the prevailing notion of the limited liability effect of debt financing. In addition, we represent that a
firm's competitive position significantly influences its choice of capital structure. The rest of this paper is organized as follows.
Section 2
describes our data, variable definitions, sample characteristics, and empirical methodology.
Section 3
presents the
results of empirical tests.
Section 4
concludes.
This paper examined the effect of capital structure on the competitive position of firms in the product market as measured
by market share. Alternatively, we assumed that a firm's capital structure influences its market share, and vice versa. We verified
the relationship between capital structure and market share through simultaneous equations in which both variables are
endogenous.
Theoretical predictions suggested that the interaction between capital structure and market share depended on whether
Cournot or Bertrand competition presided in the output market. Therefore, we classified our sample into Cournot or Bertrand
competition on the basis of empirical measures of strategic substitutes and strategic complements.
We presented evidence that leverage affects market share positively under both Cournot (strategic substitutes) and Bertrand
competition (strategic complements). This evidence supports the prevailing notion of the limited-liability effect of debt financing.
Alternatively, market share affects leverage significantly and negatively regardless of whether firms compete as substitutes or
complements. This result implies that firms enjoying a high market share restrict debt financing, perhaps to maintain their
competitive advantage in case agency costs outweigh the strategic benefits associated with the increase in debt. Our evidence
suggested that a firm's capital structure influences its market share, and vice versa. We determined that leverage is in equilibrium
when the strategic benefits of debt equal the agency costs associated with its increase
