Explicit and Implicit Contracts with Non-Financial Stakeholders and Corporate Capital Structure: The Case of Product Warranties

Abstract

We use a unique dataset of product warranty offerings by firms to investigate the effect of a firm’s warranty reserve levels on its capital structure decisions. Our sample consists of firms that (i) offer explicit warranties, (ii) likely offer implicit product warranties, and (iii) are in non-warranty-offering industries. For the whole sample, we find that leverage relates negatively to the firm’s warranty level. Further, we find that firms that offer implicit warranties have lower debt levels than firms in non-warranty industries and that, conditional on operating in a warranty-offering industry, firms that issue explicit warranties tend to have even lower debt levels. We also investigate the determinants of the product warranty decision, and find that firms offer explicit warranties when products are more differentiated, when uncertainty about product quality is high, and when sellers have private information on product quality. We then show that the negative relation between firm’s debt and warranty levels continues to hold even after we control for self-selection by firms into offering explicit warranties. Our research contributes to the literature that examines how contracting with non-financial stakeholders such as customers affects the firm’s financing decision.