Capital Structure, Product Market Dynamics, and the Boundaries of the Firm
Boston University School of Management
Richmond D. Mathews
University of Maryland - Department of Finance
David T. Robinson
Fuqua School of Business, Duke University; National Bureau of Economic Research (NBER)
July 2, 2012
AFA 2012 Chicago Meetings Paper
We study how interactions between financing and investment decisions can shape firm 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 firm (Integration) or by a separate, specialized firm (Non-Integration). Starting from a standard theoretical framework, in which value-maximizing corporate investment and financing 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 financial flexibility. These forces drive different organizational equilibria depending on firm and product market characteristics. In particular, we show that increases in standard measures of cash flow risk predict exploitation of new opportunities by specialized firms, 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 different 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.
The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2443868
Number of Pages in PDF File: 52
Keywords: capital structure, corporate investment, organizational design, real options
JEL Classification: G13, G31, G32, G33
Date posted: February 23, 2011 ; Last revised: May 30, 2014
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