The Impact of Capital Structure on Efficient Sourcing and Strategic Behavior

We model the capital structure choice of a firm that operates under imperfect competition. Extant literature demonstrates that debt commits a firm to an aggressive output stance, which is an advantage to the firm under Cournot competition. However, empirical evidence, indicates that debt is, in fact, a disadvantage under imperfect competition. We reconcile the theory with the evidence by incorporating firms' relations with their suppliers, in a model of strategic firm-rival interactions. Under imperfect competition and incomplete contracting, we show that although debt financing improves a firm's input sourcing efficiency it could also benefit the firm's rivals by lowering their input costs. This effect offsets the benefits due to aggressive product market strategies that result from increased debt. Under certain conditions this subsidy effect is sufficiently strong that debt is suboptimal in equilibrium and leads to an increase in rival's shareholder value. Copyright 2000 by MIT Press.