Paper Spotlight: Optimal Capital Structure with Imperfect Competition

Alexei Zhdanov

Egor Matveyev

Why do firms in the same industry often have different leverage levels? In their paper “Optimal Capital Structure with Imperfect Competition,” Egor Matveyev and Alexei Zhdanov show that strategic interaction alone can generate this difference. The authors first exhibit a theoretical model in which two ex ante identical firms are deciding when to enter an industry and also how much debt to issue. The product price depends both on the aggregate quantity and on a stochastic shock to the demand curve. In the overall equilibrium of the model, one firm (which becomes an incumbent) enters in a relatively low demand state with a correspondingly low amount of debt. The second firm, the new entrant, enters the industry in a high demand state, and with more debt than the incumbent. Thus, not only do ex ante identical firms in the industry have different leverage levels, but a sharper prediction emerges: Younger firms are more levered than older ones. As a result, younger firms are more likely to fall into financial distress. Further, the dispersion in leverage naturally relates to industry features such as cash flow volatility, tax rate, and bankruptcy costs. The authors then test these predictions on U.S. public firms. Indeed, as predicted by the model, leverage is negatively correlated with firm age, and firms that go bankrupt tend to be younger. To study leverage dispersion, they construct pairs of firms that are close rivals within each industry, and find that leverage dispersion is positively related to cash flow volatility, and negatively to tax rates and asset tangibility. Overall, the empirical results support the idea that strategic interaction is an important driver of differences in leverage.

Spotlight by Uday Rajan
Photos courtesy of Egor Matveyev and Alexei Zhdanov
First published February 4, 2022

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