Capital Structure and Imperfect Competition in Product Markets (Revised: 20-85 and 11-87)

Franklin Allen

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: In this paper a theory of capital structure based on imperfections in firms' product markets is illustrated with numerical examples. In the model used there is a corporate tax advantage to debt but there are no direct bankruptcy costs. The effect of bankruptcy rather is to delay investment decisions. Although these delays are not in themselves costly, they can put the bankrupt fit at a strategic disadvantage and can result in the firm being forced to liquidate. In order to prevent this happening it is optimal for firms to use a sufficient amount of equity in their capital structure to prevent bankruptcy.

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