Capital Structure, Product Market Dynamics, and the Boundaries of the Firm

We study how interactions between nancing and investment decisions can shape rm boundaries in dynamic product markets. In particular, we model a new product market opportunity as a growth option and ask whether it is best exploited by a large incumbent rm (Integration) or by a separate, specialized rm (Non-Integration). Starting from a standard theoretical framework, in which value-maximizing corporate investment and nancing decisions are jointly determined, we show that Integration best protects assets in place value, while Non-Integration best protects the value of the growth option and maximizes nancial exibility. These forces drive dierent organizational equilibria depending on rm and product market characteristics. In particular, we show that increases in standard measures of cash ow risk predict exploitation of new opportunities by specialized rms, while increases in product market risk (i.e., the risk of preemption by competitors) predict exploitation by incumbents. We also show that alliances organized as licensing agreements or revenue sharing contracts sometimes better balance the dierent sources of value, and thus may dominate more traditional forms of organization. These key results arise from the dynamic interaction of the new opportunity’s option-like features with realistic competitive forces.