Competitive Equilibrium With Debt

Abstract

This paper studies the interaction among financing, entry, and exit decisions of firms in a competitve industry subject to aggregate uncertainty. In contrast to Fries, Miller and Perraudin (1997), I do not assume that a firm in default leaves the industry immediately. The implications on the optimal leverage ratios and equilibrium credit spreads are discussed. It is shown that by incorporating the effect of competition, the model results in significantly higher credit spreads than those predicted by traditional single-firm models. Dynamic capital structure strategies in a competitive industry are also examined. The model renders a number of empirical predictions regarding leverage ratios and credit spreads of firms in a competitive industry.

Keywords: Real Options, Capital Structure

JEL Classification: G13, G32