Strategic Debt in Vertical Relationships

Gianni deFraja and Claudio Piga ()
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Gianni deFraja: University of York
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No 59, Econometric Society World Congress 2000 Contributed Papers from Econometric Society

Abstract: We study a vertical relationship between two firms, and we show that the extent of the downstream firm's borrowing affects the contract offered by the upstream firm. We establish a negative relationship between the level of debt and the downstream firm's probability of bankruptcy. We also show that, unless the interest rate is very high, there exists a conflict of interest between the upstream and the downstream firm: the latter wants to take on more debt than the former would like it to. We interpret this finding as an explanation of the constraint imposed by franchisors on the debt level of their franchisees. Such a result is tested using a dataset combining both survey and balance sheet data. We find some support for our theoretical prediction that agent firms can use debt strategically.

Date: 2000-08-01
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