Optimal Capital Structure, Capacity Choice, and Product Market Competition

This paper develops a dynamic trade-off model to study the interaction between product market competition and capital structure. Firms make interdependent entry, investment, financing and default decisions. Trade-off between tax benefits, bankruptcy costs and strategic considerations in the product market determines optimal capital structure. The model delivers the following results that are consistent with empiri-cal evidences: (1) Firms may have non-linear and non-monotonic reactions to their competitors ’ change of leverage, depending on their original levels of leverage; (2) The within-industry variation of leverage can be large, because incumbents and entrants use leverage strategically differently; (3) Entrants have higher leverage than incumbents in equilibrium, because the incumbents use lower leverage to gain strategic advantages over the entrants