Capital Structure and Interaction Among Firms in Output Markets - Theory and Evidence

Abstract

I develop a simple model that examines the relations between the extent of competitive interaction among firms in output markets, their capital structures, and the aggressiveness of their operating strategies. A firm's optimal leverage is related to the degree to which its operating strategy affects its rivals' value functions and resulting optimal output market choices. This relation is positive, regardless of whether the competition in output markets is in strategic substitutes or in strategic complements. I test the model's prediction using two proxies for the extent of competitive interaction among firms. The empirical evidence, obtained using 54 years of Compustat data, provides a strong support for the model.

Keywords: Capital Structure, Output Markets, Competitive Interaction

JEL Classification: G32, D43