Debt, investment, and product market competition: A note on the limited liability effect

This paper extends a model by Brander and Lewis [Brander, J. Lewis, T., 1986. Oligopoly and financial structure: The limited liability effect. American Economic Review 76, 956-970] on the relationship between capital structure, investment and product market competition based on the limited liability effect of debt. Empirical papers (see for example Campello [Campello, M., 2003. Capital structure and product markets interactions: Evidence from business cycles. journal of Financial Economics 68, 3533781, and Chevalier [Chevalier, J., 1995a. Capital structure and product market competition: Empirical evidence from the supermarket industry. American Economic Review 85, 415-435; Chevalier, J., 19951). Do LBO supermarkets charge more? An empirical analysis of the effect of LBOs on supermarket pricing. journal of Finance 50, 1095-1112]) generally reject the limited liability theories in favor of the predatory theories because leverage leads to less investment and weaker product market competition. This paper shows that when firms also have an investment choice, leverage can lead to weaker product market competition in a limited liability model. In addition, non-zero leverage is still optimal within this model based solely on the limited liability effect. In predatory models debt is motivated by issues outside of product market concerns, for example to solve an agency problem. Finally, this model is also consistent with the investment decisions documented empirically. (C) 2008 Elsevier B.V. All rights reserved