Firms do not operate in isolation. They are in constant strategic interaction with other firms, struggling for customers and market shares. While some firms have the luxury of operating in less competitive product markets, others face severe competition. This intense competition fundamentally affects the firms’ operating decisions and cash flows. While recent evidence supports the view that the intensity of competition has important implications for firms’ cash flows and stock returns (Gaspar and Massa, 2006; Hou and Robinson, 2006; Irvine and Pontiff, 2009; Hoberg and Phillips, 2010; Peress, 2010), the effect of competition on the pricing of debt has so far remained unclear.
This lack of evidence is surprising. Debt is the dominant source of external finance and is crucial for firms’ operating flexibility and for the financing of real investment activities. It is, therefore, important to understand whether and how the intensity of product market competition affects the pricing of debt contracts. This paper aims to fill this gap and empirically investigates the relation between product market competition and spreads of bank loans.
There are a number of potential reasons why the price at which banks lend to firms may depend on the competitive landscape. One reason relates to a firm’s default risk. Firms with a higher default risk tend to pay higher rates for their loans. Since competition reduces pledgeable income and increases cash flow risk, it could also increase firms’ default risk. Moreover, firms constantly face a competitive threat from their rivals. For instance, financially strong firms could adopt aggressive competitive strategies that can significantly increase the default risk of incumbent firms (Bolton and Scharfstein, 1990). Alternatively, if firms cannot fully exploit their investment opportunities, they risk losing these opportunities and market share to rivals. In both of these scenarios, the intensity of competition could increase the likelihood that firms default on their interest payments.
Another reason relates to a firm’s asset liquidation value. When contracts are incomplete and transaction costs exist, liquidation values are of central importance for the pricing of debt contracts. Higher liquidation values allow firms to obtain lower rates for their loans (see, for instance, Benmelech, Garmaise, and Moskowitz, 2005). The liquidation value, however, also depends on potential buyers of assets, and on the asset specificity and illiquidity of an industry (Shleifer and Vishny, 1992). When industries experience high asset illiquidity, potential buyers may not be able to acquire a defaulted firm’s assets. These assets would then trade at a discount compared to the value in best use. Fierce competition could magnify this fire sales effect and depress liquidation values even more, which in turn would affect the cost of debt financing.
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Competition and the Cost of Debt
