Imperfect Competition, Debt, and Exit

We show that an unprofitable firm in an oligopoly product market may motivate a favorable merger by committing to continue production, thereby dissipating industry profits. A sufficiently high level of debt financing makes the firm's production decision optimal for its equityholders. We show conditions for this production decision to be renegotiation-proof. Our analysis also applies to firms that are under bankruptcy protection, which enables them to finance continued operations with new debt. The empirical implications of our analysis relate takeovers of distressed firms to the nature of product market competition, the firms' debt policy, and the regulatory environment.