Ebook Efficiency, Leverage and Exit: The Role of Information Asymmetry in Concentrated Industries
Exit and contraction decisions are an important part of a firm’s strategic planning as much as investment and expansion policies. A number of factors related to the states of the economy and the industry as well as to the firm characteristics can contribute to a firm’s exit decision from its product market. For instance, firms may be operating in mature industries in which demand may be shrinking, rendering firms unable to cover their costs. Likewise, a recessionary period may lead a firm to experience difficulties it has not encountered in a boom period with high asset values. Industry concentration and firm characteristics can be another crucial factor in the exit decision. In an oligopolistic market, for example, a firm may engage in predatory pricing, in expectation of inducing higher exit probability of a weaker competitor (see Chevalier and Scharfstein (1996) and Klemperer (1995)). In sum, exit decisions can be attributed to a complex interplay of several factors ranging from the aggregate to the individual firm level.
Firm characteristics can be perceived as a channel through which macroeconomic conditions and industry factors determine the exit decision. The same economic factors will affect firms differently as they exhibit cross sectional asymmetries. One important firm characteristic is the financial structure. Over the past two decades, there has been a surge in interest in the relationship between product market competition, on the one hand, and capital structure on the other hand. Some theoretical models such as those of Brander and Lewis (1986) and Maksimovic (1988) predict a more aggressive competitive behavior as a result of higher leverage while others show that leverage makes product market competition softer. The relationship has also come under scrutiny in the empirical literature that focuses on pricing and exit decisions. Chevalier (1995), for example, explores the effect of leveraged buyouts (LBOs) on the pricing in the supermarket industry. She finds that in markets in which rival firms are also highly leveraged, prices rise following the LBO. She also finds evidence of predatory pricing in markets in which the LBO firm faces less leveraged rivals. Similarly, Phillips (1995) and Phillips and Kovenock (1997) investigate the effect of large recapitalizations on the subsequent product market performance and survival of firms. They find that firms that have undergone a large recapitalization are less likely to invest and more likely to shut down plants.
lthough understanding the role of financial leverage in pricing and exit decisions is important, the picture remains inherently incomplete without understanding the link between firm efficiency and financial leverage and its implications for firm exit decisions. Dun and Bradstreet (1980) report, for instance, that about 90% of business failures in the United States and Canada relate to firm inefficiencies. More recently, studies by Zingales (1998)and Khanna and Tice (2005) present evidence that both factors are crucial in product market pricing and exit decisions. Zingales (1998) investigates firm survival in the trucking industry around the exogenous shock of the 1979 deregulation. He points to the role of capital market imperfections and shows evidence that high leverage increases the probability of exit 8 years after the deregulation, particularly in the more imperfectly competitive segment of the industry. Interestingly, although efficiency and survival probability are positively related, he also finds that efficient high-debt firms leave the market after a negative shock. His study ties the negative effect of leverage to the reduced investment and the post-deregulation induced price war. Similarly, Khanna and Tice (2005) explore the exit and pricing decisions of discount stores across business cycles. They present evidence that confirm a positive relation between financial leverage and probability of exit and a negative relation between efficiency and probability of exit. The interesting result in Khanna and Tice (2005) is that, during recessions, efficient highly leveraged firms are more likely to exit the market. Like Zingales (1998), Khanna and Tice (2005) relate this finding to the price cutting behavior of the rivals in markets with heterogeneously levered firms. In sum, both papers demonstrate the importance of capital market imperfections: these imperfections can lead to the exit of the otherwise ”fit” firms out of the product markets.
In this paper, I propose a real options model of imperfect competition with asymmetric information that analyzes a firm’s exit decision. The decision to exit is linked to macroeconomic factors such as the level of interest rates, industry characteristics such as demand growth and volatility as well as to firm characteristics represented by financial leverage and firm efficiency. Importantly, I investigate the impact of information asymmetry as part of industry characteristics. Information asymmetry, particularly in concentrated industries, is a crucial factor that impacts the strategic behavior of incumbent firms. Firms form their competitive strategies conditioning on the amount of information they are able to gather about their rivals. In the model, firms update their conjectures based on the actions of their rivals.
Given these conjectures, firms optimally choose when to exit the market. The model links this exit decision to firm leverage. However, I define firm leverage more broadly as the sum of financial leverage and operating lever age. Operating leverage arises due to the fixed costs incurred to continue operations. I use operating leverage as the efficiency parameter: an efficient firm has a lower operating leverage, ceteris paribus. Using this specification allows me to capture the idea that high financial leverage and high inefficiency are the measures of firm weakness and make the firm more likely to exit market, as documented in the literature. It also allows me to define various competitive environments based on firms’ relative strength. Different competitive environments, in turn, have different equilibrium implications.
There are several interesting results that emerge from the model. First, I show that, under certain competitive environments, rival actions reveal private information. The information revelation allows the stronger firm in terms of total firm leverage to outlive its competitor. At the same time, without conditioning on business cycles, the model does capture the Khanna and Tice (2005) evidence that high-debt efficient firm can be driven out of the market. I show that this is the case so long as the portion of total firm leverage accounted for by debt is above a certain threshold, which, in turn, depends on the total leverage of the product market rivals. This new finding has important implications for the capital structure choice of firms in concentrated industries. In particular, the relation implies that a firm’s debt capacity is a function of its rivals’ leverage. To the best of my knowledge, this is a new prediction in the literature.
Second, I derive the equilibrium conditions under which information revelation breaks down and devise an equilibrium that supports the exit of the stronger firm. This result is particularly important as it raises the possibility that informational asymmetries can prove to be crucial in the outcome of product market competition. The result relies on the ability of a weaker firm to imitate a stronger firm. This ability is linked to the competitive environment. In a sense, this result augments the empirical finding of Zingales (1998), predicting that not only the ”fittest” and the ”fattest” but also the informationally most advantageous firms survive.
Third, the model illustrates the conditions under which capital structure can be used as a strategic tool to signal information. Specifically, the model shows that a sufficiently less levered firm can increase its financial leverage to avoid imitation by a weaker firm. For signaling to take place without distorting the competitive position, the firm must have a significant edge over the rival in terms of either efficiency (i.e. operating leverage) or financial leverage. This result has important ramifications for the ex ante capital structure choice of the firms. Specifically, it implies that a firm should also take its competitive position into account when designing financial contracts.
The model is also related to the literature pioneered by Berk, Green, and Naik (1999) that ties firms’ investment and growth options to asset prices and returns. While most of these studies focus on the role of growth options, little attention has been given to the role of disinvestment and/or exit decisions. The literature offers rational explanations for the of book to-market (B/M) and size effects documented by Fama and French (1992). In Carlson, Fisher, and Giammarino (2004), for example, the B/M effect arises due to the fixed operating costs proportional to the firm capital. I contribute to this literature by modeling exit decisions and incorporating financial leverage and information asymmetry. I also derive the implications for the firms’ cost of capital. The model demonstrates that information asymmetry leads to jumps in firm value as well as risk dynamics and cost of capital. While the size of jumps depends on the extent of information asymmetry, the direction depends on industry characteristics. Specifically, the presence of competition has a tempering effect when the industry demand falls. At the same time, the presence of competition prevents a firm from capturing the monopoly rents. This tradeoff determines the direction of the jump. In addition, the model predicts that actions taken by product market rivals in concentrated industries are a risk factor and should be taken into account when assesssing expected returns. The intuition for this follows from the fact that information asymmetry and rival actions can potentially change the market structure. This, in turn, has impact on cash flows expected to be generated by the firm.
The paper fits naturally into the products markets and game theoretic real options literatures. Although these strands of literature focus more on investment decisions, there are papers that model exit decisions. Ghemawat and Nalebuff (1985) develop the equilibrium concept in a Cournot setting in which firms have different market shares and show that the firm with longer potential monopoly tenure outlasts its rival(s). The equilibrium concept of this paper resembles Ghemawat and Nalebuff’s idea. Closely related to our paper is the study of Fudenberg and Tirole (1983). As in this article, they model exit decisions with incomplete information. However, they do not consider signaling possibilities to resolve the asymmetric information. A model that does consider the effect of capital structure choice on entry and exit decisions is that of Lambrecht (2001). He explores the strategic impact of debt in a duopoly and shows that debt renegotiation can provide competitive advantage. The model developed in this paper builds on the model developed in Lambrecht (2001). The main difference between his model and the model presented here is that Lambrecht analyzes a setting with complete information. More recently, Murto (2004) and Miltersen and Schwartz (2007) develop models of exit decisions. While the former incorporates a richer set of exit strategies, the latter analyzes not only exit decisions but also switching options. In this paper, I consider simple strategies and instead focus more on the use of debt as a strategic tool. The paper also relates to those of Grenadier (1999) and Lambrecht and Perraudin (2003). Although these papers present models of investment rather than divestment decisions, they deal with incomplete information and demonstrate that the state variable carries information on which firms can base their strategies. The informative role of the state variable is a crucial factor for the exit decision in the model presented here. However, the model also shows how the informative nature of the state variable can break down and how capital structure decisions can substitute in terms of information revelation.
The rest of the paper is organized as follows. Section 2 introduces the model and derives the equilibria of interest. In Section 3, the model is analyzed further through simulations. Economic implications and testable hypotheses are also discussed in Section 3. Finally, Section 4 concludes the paper.
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