Debt, Investment, and Product Market Competition

Recent empirical literature on the interaction between capital structure, investment, and product market decisions suggests that debt leads to lower investment expenditures and weaker product market competition. The theoretical papers in this literature addresses all three of these strategic decisions, however, they only examine at most two of these decisions simultaneously and hence have been unable to fully explain the empirical finding. This paper develops a model which examines all three decisions and shows that debt and investment can be strategic substitutes in a model where firms rationally take on debt. Furthermore it is demonstrated that when firms compete in prices in the product market, an increase in debt leads to lower investment and higher prices.