The coordination role of debt.

Abstract

In less than perfectly competitive product markets, investment decisions of a given firm depend critically on the expected investment decisions of the firm's competitors and these strategic considerations affect both firm and industry profitability. Specifically, equilibrium investment levels in an industry may differ from investment levels which maximize aggregate industry payoff and firms will attempt to coordinate their investments to pareto improve profits. I suggest that coordinating industries may choose to set investments by coordinating debt levels and relying on the relationship between capital structure decisions and investment incentives to indirectly set investment levels. Specifically, I show that coordination through capital structures may be preferable to coordination through direct monitoring of reported expenditure levels when the costs of verifying expenditures are high, when the strategic costs of disclosure (which arise from the dissipation of potential individual firm profits by providing information to competitors) are high, when there are significant delays in the availability of expenditure information, and when the possibility of regulatory intervention is high. I also extend the model by allowing firms to be asymmetrically informed as to the profitability of investments and show that the incentives to exploit private information, and therefore choose different debt levels when information sets differ, are reduced when firms are successfully coordinating. Hence, a reduction in the dispersion of capital structures will accompany coordination. Using the dispersion of capital structures as an indicator of coordination, I conduct tests of my theory along with tests of extant theories of capital structure dispersion. I find, as predicted, that dispersion is lower (coordination is likely) when there are difficulties in verifying expenditures, when strategic disclosure costs are high, and when there is a high degree of regulatory oversight.