Sunday, October 7, 2012: 9:20 AM
Although most studies in both economics and finance adopt the principle of separation of financial structure choice from decisions on investment, pricing and output, it is well known in fact that in the presence of uncertainty these dual sets of decisions interact with each other. Jensen and Meckling (1976), shows that once debt has been contracted, the manager-owner maximizes equity instead of total firm value. Under limited liability in case of bankruptcy debt-holders become residual claimants, hence, a manager-owner puts no weight in the amount of losses in case of bankruptcy. This being known by potential lenders it increases the cost of debt, thus, reducing total firm value.
Despite the above, leverage may have beneficial strategic effects in oligopoly. Brander and Lewis (1986) and Showalter (1995), show that acting on behalf of equity holders induces the manager to be more aggressive in a quantity-game, and more accommodating in a price-game, since he maximizes expected profits defined only on the range of non-bankruptcy outcomes. In any other case, i.e., when negative demand shocks occur and the firm goes bankrupt, all the operating profits are used for repaying the debt holders.
In this work we examine the impact of leverage on firm’s location under demand uncertainty. We use a quadratic transportation cost model and assume uncertainty over the exact realization of the width and density of the consumer distribution. More specifically, we assume that the two ends of the distribution move inwards or outwards symmetrically, as to leave the median consumer unchanged. The density adjusts accordingly as to leave the market size constant. This situation corresponds to a case where the market size is fixed but firms are uncertain about consumer heterogeneity. We show first that increases in uncertainty over consumer heterogeneity affect location decisions, pushing both firms towards a more central location. Also, increases in uncertainty reduce firm values, despite the fact that firms are risk neutral and the expected market size, as well as the expected heterogeneity, remain constant. This is due to the fact that in states of low heterogeneity, competition is harsher. Had firms not adjusted their location in presence of uncertainty, their total value would have been reduced by less. However, if one firm adjusts and the other does not, the former gains at the expense of the latter: under uncertainty, firms face therefore a prisoner’s dilemma in the locations game.
Introducing unilateral debt after the location stage and before the price choice, changes drastically the pattern of locations. Anticipating that its rival will underwrite debt at the second stage pushes the unlevered firm outwards and the levered firm inwards. Prices and total firm values increase for both firms, with the levered firm getting the lion’s share. This is in sharp contrast with the case where locations are exogenous. In that case, while both firms gain, leverage increases the profits of the unlevered firm even more.
Despite the above, leverage may have beneficial strategic effects in oligopoly. Brander and Lewis (1986) and Showalter (1995), show that acting on behalf of equity holders induces the manager to be more aggressive in a quantity-game, and more accommodating in a price-game, since he maximizes expected profits defined only on the range of non-bankruptcy outcomes. In any other case, i.e., when negative demand shocks occur and the firm goes bankrupt, all the operating profits are used for repaying the debt holders.
In this work we examine the impact of leverage on firm’s location under demand uncertainty. We use a quadratic transportation cost model and assume uncertainty over the exact realization of the width and density of the consumer distribution. More specifically, we assume that the two ends of the distribution move inwards or outwards symmetrically, as to leave the median consumer unchanged. The density adjusts accordingly as to leave the market size constant. This situation corresponds to a case where the market size is fixed but firms are uncertain about consumer heterogeneity. We show first that increases in uncertainty over consumer heterogeneity affect location decisions, pushing both firms towards a more central location. Also, increases in uncertainty reduce firm values, despite the fact that firms are risk neutral and the expected market size, as well as the expected heterogeneity, remain constant. This is due to the fact that in states of low heterogeneity, competition is harsher. Had firms not adjusted their location in presence of uncertainty, their total value would have been reduced by less. However, if one firm adjusts and the other does not, the former gains at the expense of the latter: under uncertainty, firms face therefore a prisoner’s dilemma in the locations game.
Introducing unilateral debt after the location stage and before the price choice, changes drastically the pattern of locations. Anticipating that its rival will underwrite debt at the second stage pushes the unlevered firm outwards and the levered firm inwards. Prices and total firm values increase for both firms, with the levered firm getting the lion’s share. This is in sharp contrast with the case where locations are exogenous. In that case, while both firms gain, leverage increases the profits of the unlevered firm even more.