The strategic use of debt reconsidered

SOM-Theme E: Financial markets and institutions Wanzenried (2003, International Journal of Industrial Organization 21(2), 171-200) considers a two-stage differentiated goods duopoly model with demand uncertainty linking firms ’ capital structure choice to their output market decisions. Unfortunately, her analysis is flawed. We correct for this, and solve the model numerically to find some results that are qualitatively different from hers. First, in equilibrium, the use of debt always yields lower firm profits, i.e. even in the case of complements. Second, the equilibrium debt level decreases as demand becomes more volatile. We also discuss some problems with the debt contract commonly used in the strategic debt literature