Capital Structure and Competitive Strategy

P.V. Viswanath

Financial Theory and

Strategic Decision-Making

OutlineCapital Structure and Consumers

Capital Structure, Financial Distress and Consumer ConfidenceFinancial Distress and Reputation

Capital Structure and the Supply ChainCapital Structure and Suppliers

Capital Structure and Employment DecisionsCapital Structure and Employees

Credible CommitmentCapital Structure and Hiring DisciplineLeverage & Collective BargainingCapital Structure and Employment DecisionsLeverage & Bargaining with the Government

OutlineDebt Overhang and Negotiating with CreditorsCommitment and StrategyCommitment vs. InvolvementCredible CommitmentCommitment with Financing PolicyCapital Structure and Competitive StrategyDebt and AggressionDebt Overhang and CommitmentDiscount Rates and AgressionDebt and PredationDebt and AgressionCash and AgressionExcess Debt & Customer ConfidenceCapital Structure and Location

Capital Structure, Liquidation and Consumer Confidence

We have seen that a leveraged firm is less likely to liquidate.However once a firm goes bankrupt, lenders get some say in firm decisions through the bankruptcy process, and lenders prefer liquidation because they get paid first from liquidation.Liquidation affects customers of firms that make durable products.Since a liquidated firm will no longer produce, customers are unlikely to get replacement parts.Warranties are also less likely to be honored.As a result, customers are less likely to buy durable products from firms that are likely to be liquidated.This suggests that a firm’s capital structure could affect the efficacy of marketing strategies. Alternatively, lack of leverage could be used in a firm’s advertising.

Capital Structure, Bankruptcy and Consumer Confidence

Are Consumers Affected by Durable Goods Makers’ Financial Distress? The Case of Auto Manufacturers by Hortacsu et al.

We find that an increase in an auto manufacturer’s financial distress (as measured by an increase in its CDS spread) does result in a contemporaneous drop in the prices of its cars at auction, controlling for a host of other influences on price.Furthermore, cars with longer expected service lives (those within manufacturer warranty, having lower mileage, or in better condition) see larger price declines than those with shorter remaining lives. These patterns do not seem to be driven solely by reduced demand from auto dealers affiliated with the troubled manufacturers or by contemporaneous declines in new car prices.

http://home.uchicago.edu/syverson/financeanddurables.pdf

Financial Distress and Reputation

We have seen that the likelihood of financial distress can provide an incentive for firms to become short-sighted and to take risky, and NPV<0 projects.Non-financial stakeholders are therefore likely to be concerned that a distressed firm will become capital constrained, which could then cause managers to make short-sighted cutbacks in value-increasing investments. Critical among such investments are the money and effort spent in maintaining the firm’s reputation for dealing honestly with employees and suppliers, and for providing quality products to its customers.

http://www2.mccombs.utexas.edu/faculty/andres.almazan/Article6.pdf

Under normal circumstances, managers have strong incentives to maintain their firms’ reputation because that contributes to higher long run profitability.Under financial duress, however, the long-run value of a good reputation may be less important than the immediate need to generate cash to stave off bankruptcy. For this reason, a firm may lower the quality of its products in order to raise cash to meet debt obligations.

Financial Distress and Reputation

Excess Debt & Customer ConfidenceOnce we note the impact of leverage on customer confidence, it’s easy to see that a potential solution to the problem is recapitalization.The problem is that it is precisely in this situation that funds are difficult to come by.Furthermore, recapitalization can have the effect of transferring value to debtholders.However, if the problems of the firm are purely financial and the business model is good, it may be possible to attract PIPE (Private Investment in Public Equity) if the firm is publicly held, or private equity if the firm is privately held. If the effect on customer confidence is high, it could trump the loss in shareholder value due to wealth transfer to bondholders.

Capital Structure and Suppliers

“Retailers rely heavily upon their suppliers for financing. These suppliers, in turn, regulate their own risk exposures through their selection of customers, and tend to respond rapidly to changes in customer creditworthiness.” “Just so with Hechinger Co., a U.S.-based retailer of do-it-yourself home products. In 1999, Hechinger defaulted on an interest payment. Anxious suppliers cut back on credit, intensifying Hechinger’s cash crunch. During the critical warm months when do-it-yourself sales typically peaked, potential Hechinger customers were greeted by nearly empty stores, leading to rapid deterioration of the firm’s condition as customers left to shop elsewhere. Hechinger was soon forced to liquidate its operations.”Clearly, suppliers may be unwilling to provide a firm with inventory if they think they might not be paid. Here’s another example:(Corporate Finance, London: Feb 2002, issue 207, p. 8) Many Kmart shoppers have suffered the embarrassment of being strapped for cash at the checkout, but this time the shoe is on the other foot. Discount retailer Kmart did not have enough money to pay Fleming Companies, its food supplier, and filed for bankruptcy in January. Fleming is owed $77 million, and joined the tough suppliers who suspended shipments to the struggling retailer - the final blow for Kmart, who promotes itself as the home of low prices.

Integrated Risk Management for the Firm: A Senior Manager’s Guide, Lisa K. Meulbroek, 2002

Capital Structure and Suppliers

Kimberley Blanton’s article in The Boston Globe on Thursday December 4, 1997 (City Edition) cites: “… the Chapter 11 filing in US Bankruptcy Court in Boston by Waltham-based Molten Metal was triggered when suppliers refused to extend additional credit to the company, which had already slowed payment of its bills.”Molina and Preve also find that retailers are forced to reduce their dependence on trade credit in times of financial distress.Clearly financial distress can impact on a firm’s relations with suppliers.It is obvious that financial distress has a lot to do with a firm’s choice of financial leverage. The greater the debt in the firm’s capital structure, the greater the likelihood of financial distress. Suppliers are likely to look at these factors in deciding on the terms to grant their customers. A savvy firm can use its financial stability to bargain for better credit terms.

An Empirical Analysis of the Effect of Financial Distress on Trade Credit, Molina and Preve, 2007

A highly leveraged firm is more likely to go bankrupt and a bankrupt firm is more likely to be liquidated.Highly levered firms have a greater tendency to lay off workers and reduce employment in response to a short-term reduction in demand.A firm with less onerous debt obligations may be willing to maintain high employment when times are bad, in order to reduce the future costs of hiring and retraining workers when demand increases. That is, this is the first-best optimum.However, a more highly levered firm may be forced to cut costs by laying off workers to meet its debt obligations.It cannot raise funds even to fund carrying unnecessary workers short-term because levered firms have perverse incentives, as we have seen. Levered firms that are close to financial distress are likely to be myopic in their investments.

Capital Structure and Employees

Capital Structure and HRA disbelieving financial analyst might make a comment such as the following statement:A firm in financial distress will lay off workers because it doesn’t have sufficient funds. This has nothing to do with capital structure.Can you convince her otherwise?

Capital Structure and Hiring DisciplineFor the last two decades, firms with higher debt have reduced their employment more often, used more part time and seasonal employees, paid lower wages, and funded pension plans less generously. These effects are economically significant and cannot be explained by variation in performance. Debt seems to discipline the employment relationship.The apparent employment effects of debt are not substantially affected by controls for growth opportunities. The relation between debt and employment reductions is significant only at high debt levels, suggesting that only high debt levels can force employment reductions.

Debt and the terms of employment, Gordon Hanka, JFE 1998

Leverage & Collective Bargaining

Can capital structure have an impact on a firm’s collective bargaining?Here’s a statement from an Eastern Airlines union leader:More debt for Eastern meant greater pressure to cut costs. . . . [The company] is embarked on a confrontation between labor and interest costs. It’s not labor and management. It’s labor and interest cost.

Farrell Kupersmith, Pilots’ Union Representative

So it seems some people think so. But what is the nature of this connection?

Leverage & Collective Bargaining

David Matsa analyzed the strategic use of debt financing to improve a firm’s bargaining position with organized labor. Because maintaining high levels of corporate liquidity can encourage workers to raise their wage demands, a firm with external finance constraints has an incentive to use the cash flow demands of debt service to improve its bargaining position with workers. Using both firm-level collective bargaining coverage and state changes in labor laws to identify changes in union bargaining power, Matsa showed that strategic incentives from union bargaining appear to have a substantial impact on corporate financing decisions. In other words, firms with excess cash cannot credibly threaten labor demands with dire consequences. Hence it might make sense for a firm to have large amounts of debt that might enable it to force labor to make concessions at difficult times. Thus, in good times, leverage increases ROE, while, in bad times, it can reduce labor costs.Capital Structure as a Strategic Variable: Evidence from Collective

Bargaining, David Matsa, JF 2010

Leverage & Collective Bargaining

Here’s an example from the airline industry:Airlines in financial distress obtain wage concessions from employees whose pension plans are underfunded in that plan assets are insufficient to cover outstanding liabilities. Since employees with underfunded pension plans bear a higher cost when firms default, their outside option in the event of default is reduced. Therefore, in bargaining, management can employ the threat of ‘pension dumping’ to extract greater concessions from labor. Pensions are partially insured by the PBGC. Since highly-paid employees with promised pensions that exceed the PBGC guarantee stand to lose more when their pension is dumped, they are more likely to make concessions during labor bargaining.In renegotiation financially constrained airlines with underfunded pension plans extract between $12,252 and $17,360 in annual wages from employees not fully covered by the PBGC guarantee.Negotiating with Labor under Financial Distress, Benmelech et al.

Financial Leverage and Leverage Over Labor

Jayant Kale, Harley Ryan and Lingling Wang in a paper entitled “Outside Employment Opportunities, Employee Productivity, and Debt Disciplining” show that debt in the capital structure increases the productivity of the firm’s employees.They also find that this positive productivity-leverage relation becomes stronger when outside employment opportunities for employees worsen. They look at the effects of the implementation of NAFTA, an exogenous shock to employment opportunities in certain industries; on average, it strengthened the positive productivity-leverage relation for firms in these industries.This suggests that debt increases labor productivity by means of the increased leverage that the firm has on its employees.

Leverage & Bargaining with the Govt.

Too large to fail? Can a firm be too important to a local government to fail?If there are positive externalities to the operations of a firm, in terms of employment of the local population with the attendant positive effects of lower crime etc., governments might be willing to provide guaranteed loans to such firms in the event of financial distressThus, the US government guaranteed loans to Chrysler and received warrants in return.The Canadian government provided guarantees to Massey-Ferguson on a preferred stock issue in return for a promise not to lay off workers in Canada.Thus capital structure and financing policy can be a means for a firm to extract the value of positive externalities.

Debt Overhang and Negotiating with Creditors

Similarly, excessive debt leading to debt overhang and inhibited investment can lead to a stronger negotiating position vis-à-vis bondholders. The debt-overhang problem may be so severe that creditors can actually benefit from forgiving a portion of the debt. With excessively high levels of debt, the risk of default is large and the market value of debt is well below its face value. If the creditors forgive part of the debt in this situation, the lower debt burden helps realign the interests of the equity holders and the creditors. The firm’s effort and investment will rise, increasing the total value of the firm and the market value of the remaining debt. If this effect is strong enough, the market value of the remaining debt may be even higher than the market value of the total debt in the absence of debt forgiveness, in which case debt relief will ultimately benefit the creditors themselves.

http://www.clevelandfed.org/research/commentary/2010/2010-7.cfm

Commitment and StrategyConsider the following chicken game: Manny

Danny

Swerve Straight

Swerve Tie, Tie Lose, Win

Straight Win, Lose Crash, Crash

Because the loss of swerving is so trivial compared to the crash that occurs if nobody swerves, the reasonable strategy would seem to be to swerve before a crash is likely. Yet, knowing this, if one believes one's opponent to be reasonable, one may well decide not to swerve at all, in the belief that he will be reasonable and decide to swerve, leaving the other player the winner. This game has no symmetric Nash equilibrium in pure strategies. If Manny is going to swerve, then Danny should go straight. If Manny is going to go straight, then Danny should swerve (assuming losing is better than crashing).In other words, there is unresoluble uncerrtainty in this game.

Commitment and StrategyOne tactic in the game is for one party to signal their intentions convincingly before the game begins. For example, if one party were to ostensibly disable their steering wheel just before the match, the other party would be compelled to swerve. This shows that, in some circumstances, reducing one's own options can be a good strategy. One real-world example is a protester who handcuffs himself to an object, so that no threat can be made which would compel him to move (since he cannot move). Another example, taken from fiction, is found in Stanley Kubrick's Dr. Strangelove. In that film, the Russians sought to deter American attack by building a "doomsday machine," a device that would trigger world annihilation if Russia was hit by nuclear weapons or if any attempt were made to disarm it. However, the Russians failed to signal—they deployed their doomsday machine covertly.Obviously, this will not elicit the desired response from the opponent, i.e. backing down. Revelation of the signal is key.

Source: Wikipedia

Mike ShorGame Theory & Business Strategy 22

Commitment vs. Involvement

Two firms considering market entry:Market potential is $10 million NPV profitsEntry costs $7 million; if both enter, both firms lose.

It is in our best interest to stay out if we think that the other firm will enter

In Out

UsIn -2 , -2 3 , 0

Out 0 , 3 0 , 0

Them

Mike ShorGame Theory & Business Strategy 23

Involvement

We make an initial investment:Invest first $1 million to deter entry, which is lost if we then quit.

It is still in our best interest to stay out if we think that the other firm will enter

In Out

UsIn -2 , -2 3 , 0

Out -1 , 3 -1 , 0

Them

Mike ShorGame Theory & Business Strategy 24

Commitment

We make an initial investment:Invest first $3 million to deter entry

Now, it is our dominant strategy to enter regardless of what the other firm will do

In Out

UsIn -2 , -2 3 , 0

Out -3 , 3 -3 , 0

Them

Mike ShorGame Theory & Business Strategy 25

Credible Commitment

By reducing our own payoffs from staying out, we have committed to entry

Mike ShorGame Theory & Business Strategy 26

Reducing Payoffs: Contracting

Takeover offer: $200 millionYou can “afford” $20 million / yearFinance takeover for 20 years at 7%

Add penalty: if amount greater than $200 million, +1.5 points on interest rate

Annual Payments:$200 million: $18.6 million / year$210 million: $19.6 million / yearwith penalty: $21.9 million / year

So it’s clear that the acquirer will not pay more than $200m.

Commitment with Financing Policy

Managers have an incentive to take negative NPV projects if they have private benefits (from perks) from firm investment. This would discourage outside investment and might even discourage good employees from working for the firm, if we assume that good employees would rather work for profitable firms.Hence the firm might prefer to take on debt. The existence of debt means that managers are forced to choose profitable projects. Else the firm would be forced into bankruptcy and possibly liquidation and managers would lose their firm-specific human capital.Investors/Employees would have reason to worry about suboptimal actions by management.We see that managers can use debt as a commitment device.Of course, we have also seen that debt can lead firms to underinvest and to act myopically.We see, therefore, debt might have positive and negative implications.

Capital Structure and Competitive Strategy

A competitor that believes the market leader will fight to keep its market share will be reluctant to aggressively expand its own market share. Hence the market leader can capture a strategic advantage if it credibly commits to protecting its market share aggressively.However the competitor may think that the market leader will acquiesce and give up market share rather than face a costly price war.Let us see how capital structure could be used by the market leader to convince the competitor of its commitment.

Debt, Risk-Seeking & Aggression

How can debt be used to convince competitors that the firm will increase output in a price war?Note that when aggregate demand for a product is highly uncertain, higher output generally increases risk because it leads to higher profits when product demand turns out to be high, but lower profits when demand turns out to be low.Since higher leverage increases a firm’s appetite for risk, the greater a firm’s leverage, the greater its incentive to produce at a higher level of output.Not wishing to drive the price down to where no firm profits, competitors will accommodate the firms’ high output by producing at a lower level.

However, we also know that debt financing can lead firms to reduce their level of investment.This can make the firm act less aggressively.See, for example, the case in the next slide where the firm is close to bankruptcy, and the presence of debt causes the firm to act less aggressively.This is the debt overhang problem, which also inhibits borrowing for new investment.

Debt and Aggression

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The Underinvestment Problem

Consider a firm that currently has debt with face value of $1000 that will come due in one year and assets that are projected to be worth $900 in one year.

Suppose the firm has the opportunity to invest in a new project requiring an immediate investment of $100 and offering a return of 50% in one year. Assuming the required rate of return for this project is less than 50%, it’s a NPV>0 project.

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Debt Overhang & Commitment

Suppose the only way to get the $100 for the initial investment is for the existing equity holders to contribute it.

With the new project, equity-holders will get $50 in one year for a current investment of $100 – clearly equity-holders would not make the investment even though the project has an NPV > 0. This is the Underinvestment Problem.

This problem is also known as the debt overhang problem because the existence of debt in a firm that’s close to financial distress inhibits additional borrowing and investment.

Hence if the firm is highly leveraged, debt can have the opposite effect and cannot work as a commitment device.

Debt and Aggression“(F)irms with greater access to external financing can threaten their rivals with lender-financed product market overinvestment. Facing this threat, those rivals may accommodate. Therefore, consistent with the previous evidence on firms implementing leveraged recapitalizations, debt can initially provide for a product market advantage for those firms with greater access to credit. However, in a world in which parties can renegotiate contracts, debt taking cannot support aggressive market strategies after a certain threshold”Lenders will not provide funding for high production strategies that are not sustainable by cost or other advantages. From a strategic point of view, debt can provide at least limited and perhaps temporary strategic advantages against competitors.

“Debt financing: Does it boost or hurt firm performance in product markets?,” Murillo Campello, JFE 2006

Cash and AggressionWe have seen that debt could be used by a firm to be aggressive vis-à-vis its competitors, but it could also be weakening.To the extent that debt represents access to resources, cash could be thought of as a substitute, although debt has certainly commitment characteristics which cannot be replicated by cash.Cash could, thus, help support aggressive behavior against competitors, while avoiding the potentially debilitating features of debt. Of course, excess cash could expose the firm to opportunistic suboptimal managerial behavior.It must be pointed out that predatory pricing is not the only way in which access to financing in the form of cash/debt could help a firm compete.Examples of such policies include decisions about capital outlays, research and development expenses, the location of stores or plants, distribution networks, the use of advertising targeted against rivals, the recruitment of more productive workers, or the acquisition of key suppliers or business partners

“Financial Strength and Product Market Behavior: The Real Effects of Corporate Cash Holdings,” Laurent Fresard, J of Finance, 2010

Capital Structure and Location

There is evidence that firms in the same location exhibit similar capital structures.Apparently, local culture and social interactions among corporate executives, play a significant role in influencing corporate financial policies of firms headquartered in the same metropolitan area.What does this imply for the location decision?

Does Corporate Headquarters Location Matter for Firm Capital Structure? By Wenlian Gao, Lilian K. Ng and Qinghai Wang, SSRN 2010

Capital Structure and Location

There is also evidence that firms that are located in rural areas or in areas that are distant from financial centers are more subject to information asymmetry than nearby firms. The reason is that there are fewer equity analysts in these locations. As a result, it is more difficult for such firms to obtain outside equity.Loughran and Schultz (2006) find that that rural firms wait longer to go public, are less likely to conduct seasoned equity offerings, and have more debt in their capital structure than otherwise similar urban firms. This suggests that if entrepreneurs believe that they are more likely to have difficulties in obtaining financing, perhaps because they don’t have networking capabilities, then they should locate in urban areas close to financial centers.

“Asymmetric Information, Firm Location, and Equity Issuance” by Loughran and Schultz, JFQA 2006