What has been missing

Transcription

1 What has been missing The Investment papers have made explicit or implicit assumptions: Investment is irreversible, i.e., there is no capital sale I < 0. Firms are all Equity Financed Objective Function is well defined When markets are complete, value maximization is the correct objective. If Debt is in the capital structure and firms may face bankruptcy, then investment problem and valuation of the firm is more complicated.

2 Abel and Eberly Posit and solve a dynamic investment problem with uncertainty (demand), fixed costs and reversibility Buy and Sell capital, (but at different prices) Costlessly adjust capital = mp k = r Adjustment costs = replacement cost=present and future benefit (q). Adjustment costs + uncertainty + revesibility = thresholds. For q > q 1 there is positive investment For q 2 < q < q 1, there is 0 investment For q < q 2 there is disinvestment.

3 Meaningful financial structure Hennessy (2004) Suppose that there are debt and equity holders. An Equity maximizing firm does not take into account post default investment returns Levered q = discounted value of installed capital prior to default. Levered q= unlevered q - shadow cost of capital at the time of default. So, equity maximization = less investment.

4 What is FINANCIAL DISTRESS? Or, Why does a change in ownership mean A loss in Value? Asset sales and liquidation. Reorganization and workouts. Formal reorganization. Automatic financial restructuring.

5 FINANCIAL DISTRESS The firm cannot meet a debt repayment using its liquid assets. Several options available (possibly simultaneous or sequential). Out of bankruptcy: Restructure assets. Restructure liabilities. Formal bankruptcy: Alters the powers, duties, and responsibilities of the firm s claimants. Liquidation (Chapter 7 of US Bankruptcy Code). Reorganization (US Chapter 11).

6 MAIN QUESTIONS Does financial distress reduce firm value? Does financial distress generate inefficiencies? If yes: How large are these costs? What are aggravating factors? Implications for firms and law makers? Implications for capital structure?

7 IRRELEVANCE THEOREM Haugen and Senbet (1978). Framework: Frictionless bargaining between all claimholders. Implication: Financial distress has no effect on firm value. Proof: Financial distress is induced by the firm s financial structure. Suppose that financial distress destroyed value. Coase Theorem: The firm s claimholders could bargain and restructure the financial structure in such a way that The firm exits financial distress. The inefficiency is avoided. All claimholders are better-off. Examples: Debt-for-equity exchange. Firm sold as a going concern (e.g., merger).

8 Implications Costs arise due to inefficient bargaining. Reorganization costs are an upper bound to bankruptcy costs. Hard-to-renegotiate debt Greater costs: Many creditors. Heterogenous classes of debt (maturity, seniority, security). Dispersed rather than concentrated debt: Coordination and asymmetric information problems. Arm s length rather than relationship lending.

9 Key empirical issue: Financial vs. Economic Distress Firms in financial distress tend to perform poorly. In which direction does the causality go? Distinguishing financial and economic distress empirically is difficult. Studies focus on a few relatively clear-cut cases: Cutler and Summers (1988). Hoshi, Kashyap and Scharfstein (1990). Andrade and Kaplan (1998). Asquith, Gertner, and Scharfstein (1994).

10 ASSET RESTRUCTURING Asset sales, merger. Layoffs, Capital expenditures reduction. Problems Fire-sale prices: Illiquid secondary market for asset sales. Potential highest bidders may be cash- and creditconstrained. If they are firms in the same industry. Hit by the same negative industry-wide shock as the seller. With already high debt levels. Subject to antitrust regulation.

11 Implications (Shleifer and Vishny 1992): Industry debt capacity. Firms in an industry can have different capital structures. Diversification increases debt capacity because firms can pick the industry in which to sell assets. More fungible assets increase debt capacity because they can be sold to less cash-constrained industry outsiders. Inefficient sales: The firm might end up selling assets To other firms when they should remain in the firm. To industry outsiders when they should remain in the industry.

12 LIQUIDATION OR CASH AUCTIONS Chapter 7 The court appoints a trustee who: Shuts down the firm. Sells the assets for cash to the highest bidder (e.g. the previous owners) piecemeal or as a going concern. Proceeds are divided among claimholders according to the Absolute Priority Rule (APR).

13 Problems Chapter 7 Same as for other asset sales but also new problems. Fire-sale prices: Potential buyers may be especially cash constrained given that many assets are sold simultaneously. Assets cannot be sold selectively. (Temporary) under-diversification discount (unless the buyer has already organized to off-load the risk) Inefficient liquidation: Excessive piecemeal liquidations due to the buyers cash constraints.

14 PRIVATE REORGANIZATIONS AND WORKOUTS Assets Liabilities Liquid Assets: X 0 Bank Debt: B 0 due at t = 0 Fixed Assets: A Public Debt: λp due at t = 0 Public Debt: (1 λ)p due at t = 1 Priority: A fraction φ 0 of the public debt is as senior as the bank. The other (1 φ 0 ) is junior to the bank.

15 Investment opportunity: At t = 0, investment outlay of I required. At t = 1, project generates X [0, + ) with c.d.f. H. Value (possibly negative): V = E[X] I. Problems: The firm is in financial distress: X 0 < B 0 +λp +I. The firm is insolvent: X 0 + A < B 0 + P. Solutions: Restructure bank debt and/or public debt. Raise new capital.

16 BANK DEBT RESTRUCTURING Framework: (Bulow and Shoven 1978). Public debtholders are passive in restructuring. Frictionless bargaining between the bank and equityholders. Implication: The bank and equityholders reach the coalition-efficient outcome, i.e., restructure if their joint payoff increases. Becomes like Entrepreneur (Bank + Equity) vs. passive creditor (Public debtholders) framework.

17 Restructuring will occur if and only if the investment s value exceeds the transfer to public debtholders. V V (P ). Possible investment distortions: Under-investment: 0 < V < V (P ). Investing would create value, but public bondholders would get more than all the benefit. Debt overhang. Restructuring fails. Over-investment: V (P ) < V < 0. Investing destroys value, but public debtholders incur more than all of the cost. Risk-shifting. Restructuring succeeds.

18 Transfer to Public Debtholders Gertner and Scharfstein (1991). In Liquidation: Public debtholders receive: L P 0 = ( ) φ0 P B 0 +φ 0 P (A + X0 ) if A + X 0 < B 0 + φ 0 P. A + X 0 B 0 otherwise. In Continuation: The bank issues new debt due at t = 1 : B 1 = I X 0 + B 0 + λp. A fraction φ 1 of the public debt is as senior as the new bank debt. Total debt due at t = 1 has face value: D 1 = B 1 + (1 λ)p = I X 0 + B 0 + P. The face value of senior debt is: S 1 = B 1 + φ 1 (1 λ)p = D 1 (1 φ 1 )(1 λ)p.

19 Assumption: The new debt is risky, i.e., A < D 1. Public debtholders receive: where λp + (1 λ)p if X + A D 1. L P 1 (X) otherwise. ( φ1 (1 λ)p L P 1 (X) = S 1 A + X B 1 ) (A + X) if A + X < S1. otherwise. Continuation yields a transfer to public debtholders. V (P ) = P + D 1 A 0 ( L P 1 (X) (1 λ)p ) dh(x) L P 0

20 Public Debt Maturity Longer-term public debt increases investment incentives. V (P ) λ = D 1 A 0 L P 1 (X) λ + P dh(x) 0. L P 1 (X) λ 0 but P + LP 1 (X) λ 0. Intuition: As maturity of the public debt, its value in continuation because the short-term portion is safe while the long-term portion is risky.

21 Investment efficiency: Firms with a large fraction of short-term public debt are more likely to be facing an under-investment problem. A larger fraction of short-term public debt worsens under-investment. Firms with a large fraction of long-term public debt are more likely to over-invest. A larger fraction of long-term public debt worsens over-investment.

22 Case 1: A + X < S 1. L P 1 = L P 1 λ = φ 1 (1 λ)p S 1 Proof (A + X) φ 1 S 1 (1 φ 1 )P φ 1 (1 λ) (S 1 ) 2 (A + X) P = φ 1D 1 > P S }{{ 1 } 1 Case 2: A + X > S 1. A + X L S 1 }{{} <1 P L P 1 = A + X (I X 0 + B 0 + λp ). L P 1 λ = P.

23 Priority of Existing Bank Debt More senior old bank debt decreases investment incentives V (P ) φ 0 = L P 0 φ 0 0 (and < 0 for φ 0 large enough). Intuition: Less senior existing debt makes the bank worse off in liquidation, and hence more willing to lend. Investment efficiency: Senior bank debt is likely to Worsen short-term public debt s under-investment effect. Alleviate long-term public debt s over-investment effect.

24 Priority of New Bank Debt More senior new bank debt increases investment incentives V (P ) φ 1 = D 1 A 0 L P 1 φ 1 dh(x) > 0. Intuition:More senior new bank debt makes the bank better off in continuation. Note: Public debt covenants prevent the issue of senior debt or restrict it (conditions on amount, cash flows and net worth). Investment efficiency: likely to Seniority covenants are Worsen short-term public debt s under-investment effect. Alleviate long-term public debt s over-investment effect.

25 PUBLIC DEBT RESTRUCTURING Involving the public debtholders in the restructuring could reduce inefficiencies (both under- and over-investment). Problem: The Trust Indenture Act of 1939 requires approval by all bondholders to change principal, interests or maturity. Response: Exchange offers Buy back debt with a package of new debt, equity and cash. Non-tendering debtholders maintain their claims and so the Trust Indenture Act is not violated.

26 Framework: (Gertner and Scharfstein 1991). Public debtholders can participate in the restructuring but only through exchange offers. Frictionless bargaining between the bank and equityholders. Implicit renegotiation: Even if the face value of non-tendered claims is unchanged, their actual value may be affected. Not necessarily frictionless: If there are many bondholders, each of them may not fully realize his decision s impact on the outcome. Extreme assumption: Atomistic debtholders take the outcome as independent of their decision.

27 Exchange for Same Priority or Junior Claim Consider an offer to reduce the face value from $1 and $α. Hold-out problem Each debtholder takes as independent of his decision: The amount of bank debt relief. The fraction of others debtholders who tender. The firm s decision to invest or not. He will not tender because this would reduce his payoff: At t = 0, in liquidation or continuation. At t = 1, in liquidation or continuation. The exchange offer fails even if the bondholders as a group would be better off accepting it (free-rider problem). Corollary: The same holds if short and long-term debt are different debentures. Corollary: The hold-out problem is even more severe for equity or junior debt exchanges because hold-outs are senior at t = 1.

28 Exchange for Senior Debt Exit Consent: An exchange for senior debt is achievable if a (simple or super) majority of bondholders tender. Consider an offer to exchange $1 of junior debt for $α of senior debt. Suppose all other debtholders tender. Tendering yields: αλ + Not tendering yields: λ + (1 λ)α D 1 (A + X) if A + X < D 1. (1 λ)α otherwise. 0 if A + X < D 1. (1 λ) otherwise. Tendering is (perceived as being) optimal iff: (1 λ)α (1 α) [1 (1 λ)h(d 1 A)] D 1 A (A + X)dH(X). D 0 1 There exists a unique α such that this is an equality. Tendering is (perceived as being) optimal iff α α.

29 Hold-in Problem Corollary: Exchange offers for cash are similar to offers for senior debt. As more debtholders tender, more cash is paid out at t = 0 reducing the value of old debt at t = 1. Can increase the amount of relief by public debtholders. Can lead to: Too little relief: Hold-out problem may be binding. Too much relief: The offer may succeed even if bondholders as a group would be better off rejecting it. Similar analysis for exchanges for cash or shorter maturity debt. The hold-in problem is more severe when the public debt is longer term. Short-term maturity gives effective seniority that cannot be erased by a senior debt issue.

30 Investment efficiency A senior/cash public debt exchange can reduce the company s public debt burden and promote investment. However, it could, in principle, lead to too much investment. Investment efficiency is not affected by exchange offers if there is no seniority covenant.

31 REORGANIZATION OR STRUCTURED BARGAINING Many countries provide a framework to alleviate the problems with cash auctions (not all, e.g., Norway and Sweden). Intended to promote reorganization of economically viable firms as going concerns and thereby avoid inefficient liquidation of distressed firms. Reorganization: Claims are exchanged against new ones of the reorganized firm. In effect, the reorganized firm is sold to its current claimholders (fictional liquidation as a going concern).

32 Chapter 11 Automatic Stay. Debtor-in-Possession Financing. Voting Procedure. Some facts (Franks and Torous, 1989; Weiss 1990) Routine violations of APR for unsecured creditors. Administrative fees 2% to 5% of assets. Average time in bankruptcy 20 months.

33 Automatic Stay Stops payments to unsecured creditors. Secured creditors cannot seize collateral. Executory contracts may become unsecured claims. Automatic Stay increases the firm s incentive to invest. Intuition: This effectively extends the maturity of the public debt which can relax the firm s cash constraint (if X 0 > I) and/or the firm s credit constraint (as we have seen).

34 Debtor-in-Possession Financing Subject to Court approval DIP Financing: New senior debt can be issued (even in violation of existing covenants). New debt can even be made senior to other administrative costs. Cash Collateral Agreements: Operations can be financed using liquid assets already pledged as collateral. DIP Financing increases the firm s incentive to invest. Intuition: Strip seniority covenants.

35 Reorganization Procedure Current management and board retain control. Exclusivity Period: Management retains the exclusive right to file a reorganization plan for 120 days (Extensions are common). Committees and trustees representing classes bargain over the reorganization plan (what to do with the assets + who gets what). Majority Voting Mechanism: 2/3 in face value and 1/2 bondholders in each class. Classes are determined by grouping creditors with essentially equivalent claims. Cramdown procedure: The Court can impose a plan vetoed by one class of claimants.

36 The Chapter 11 voting procedure favors investment incentives. Contrary to exchange offers, in a vote, public debtholders are not treated differently depending on their vote. Note: Under the Trust Indenture Act, firms cannot write covenants mimicking the Chapter 11 voting procedure.

37 Maintenance of Equity Value Shareholders typically receive a stake in the reorganized firm even though debtholders are not paid in full. One threat of the plan s sponsor is that the plan will be approved in a cramdown. Investment Efficiency: Chapter 11 can alleviate under-investment arising from: Short-term public debt. Seniority covenants. Existing senior bank debt. Chapter 11 s maintenance of equity value can also reduce the firm s incentive to engage in risk-shifting prior to bankruptcy.

38 OTHER BANKRUPTCY METHODS Receivership (in the UK). A large creditor (usually a bank) appoints a receiver who: Runs the firm. Decides whether to liquidate the firm or maintain it with a view to selling it later as a going concern. Problems: The bank s interest may lead to excessive liquidations. Cash auctions problems. Administration by a Court (in France). A judge runs the firm and decides what to do with the assets. Problems: Expertise? Incentives?

39 AUTOMATIC FINANCIAL RESTRUCTURING Bebchuk (1988), Aghion, Hart and Moore (1992). Main idea: In contrast to liquidation, there is no objective value to be divided among claimants in reorganization. Bebchuk s mechanism respects seniority and does not require that the true firm value be verifiable. Converting all claims into equity avoids expost conflicts and coordination problems (?).

40 Equity is like a call on the firm s assets with strike equal to the debt s face value: V E = max{0 ; V K}. Consider a firm with N classes of claimants, n = 1,..., N, ranked by seniority and with face value K 1,..., K N. Class 1 claimants (i.e., most senior) receive all the new firm s shares. Say there are S shares. Class 2 claimants receive call options on the firm s shares, Class 1 claimants take the short side. The strike price is: K 1 /S. Class n+1 claimants receive call options on the firm s shares, Class n claimants taking the short side, and with strike price: 1 S n i=1 K i.

41 Example Assume one claimant per class (for simplicity). Class N claimant (i.e., shareholders) believes the value to be V so that he should receive: max N 1 0, V i=1 K i This is indeed his call option s (perceived) payoff. If Class N exercises the call, all other classes receive their face value, i.e., class n gets K n as it: Receives M Pays M 1 i=1 i=1 K i from class M + 1. K i to class M 1. If Class N does not exercise its call, we are down to N 1 classes and the same reasoning applies.

42 Some Issues Less than the ex-post efficient number of liquidations because management remaining in place may be reluctant to liquidate. Even ex-post efficient liquidation may not be enough to provide ex-ante incentives. Ignores potential conflicts and coordination problems in all-equity firms, e.g., Conflicts between large vs. small shareholders. Dispersed shareholders leave excessive discretion to management, no longer constrained by leverage.

43 APR may be too tough on equity who may then undertake risk-shifting activities (e.g., delay the start of bankruptcy). Note: The automatic reorganization method can be amended to achieve other divisions of firm value. Nevertheless, the division is fixed while some flexibility may be key. Financially constrained junior creditors may be unable to exercise their options (see however Hart, La Porta, Lopez-de-Silanes and Moore 1996). Winner s curse due to information asymmetry. Creditors may want cash, not equity or options.

44 Empirical approach General Issues Identify samples likely to have a large fraction of financially distressed firms. Analyze firms that enter financial distress. What do firms entering financial distress do? How do they perform? How costly is financial distress? Problems Define financial distress. Hard to separate financial distress and economic distress. Sample selection and small sample.

45 DIRECT EFFECTS OF CAPITAL STRUCTURE Main idea: Capital structure can affect investment. Affects product market strategy. Debt makes you tough Debt has a disciplining effect. The firm keeps costs down. Debt makes you weak Debt overhang. Distorted investment policy. e.g., lower investment in cost reduction.

46 STRATEGIC EFFECTS OF CAPITAL STRUCTURE Main idea: Capital structure affects firms strategic interactions in the product market. Debt makes you tough: Debt induces over-investment (à la Jensen and Meckling 1976). Debt serves as a commitment to over-invest. Debt makes you weak: Leveraged firms find it harder to raise external funds. Induces under-investment (à la Myers 1977). This can be exploited by competitors.

47 LIMITED LIABILITY EFFECT Brander and Lewis (1986). Main idea: Debt induces risk-shifting by shareholders (limited liability effect). In Cournot competition under uncertainty, risk increases with the quantity produced. Debt is a commitment to be aggressive in Cournot. Model Firms 1 and 2 compete à la Cournot: q 1 and q 2. Zero marginal cost of production. Price = a b(q 1 + q 2 ) where a {a L, a H } with θ Pr [ a = a H ].

48 Denote: All-Equity Firms (standard Cournot model) â E [a] = θ a H + (1 θ) a L. Firm i s shareholders/management maximize: Reaction functions: q i [â bq i bq j ]. qi = â bq j. 2b Equilibrium quantities: q1 = q2 = â 3b, q1 + q2 = 2â 3b. Expected profits per firm: Remark: â 2 9b. The quantity q i is ex-ante optimal. Ex-post over-production if a = a L. Ex-post under-production if a = a H.

49 Effect of Leverage Assume now: Firm 1 has debt of K high enough so that K > X L 1. Firm 2 is all equity financed. Under Limited Liability, firm 1 s shareholders maximize: θ [ q 1 (a H bq 1 bq 2 ) K ] + (1 θ) 0. That is, firm 1 s shareholders ignore the bad state and maximize: q 1 (a H bq 1 bq 2 ). Hence, firm 1 s reaction function is: q 1 = ah bq 2. 2b Firm 2 s reaction function remains: q 2 = â bq 1. 2b

50 Equilibrium quantities: q 1 = â 3b + 2(1 θ) a, 3b q 2 = â 3b (1 θ) a, 3b q 1 + q 2 = 2â 3b + (1 θ) a. 3b

51 Compared to the standard Cournot outcome: Levered firm produces more. Unlevered firm produces less. Total industry output is greater. Price is lower. Intuition: An increase by Firm 1 from Cournot quantity leads to: If a = a H : Less under-production and higher profits. If a = a L More over-production and lower profits. Overall: Higher variance and lower mean of profits. Limited liability. Risk-shifting by shareholders at the expense of debtholders (as in Jensen and Meckling 1976). Firm 2 accommodates Firm 1 s more aggressive strategy.

52 Will Firm 1 Issue Debt? Equilibrium expected profit (remember that debtholders break even) = q 1 (â b (q 1 + q 2 )) â 3b + 2(1 θ) a 3b â b 2â 3b + (1 θ) a 3b = 1 9b (â + 2(1 θ) a) (â (1 θ) a ). compared with â 2 9b Firm 1 is better off with debt if : Satisfied for θ large enough. a L large enough. a H small enough. 3(1 θ)a L > (2 3θ)a H This is when the expected loss w.r.t. standard Cournot (low state) is lowest.

53 Industry Equilibrium Remark: Debt can constitute an entry barrier. Note, Firm 2 s profit are lower than in standard Cournot. Assume now that both firms are in the market: Firm 1 and 2 choose their capital structure. Both may want to lever up. Both over-produce w.r.t. Cournot. Both are worse off w.r.t. Cournot. They would be better-off committing not to lever up.

54 More general: Comments Commitment to over-invest could be used against other parties (e.g., employees, government, etc.) Sometimes might prefer committing to under-invest (e.g., Perotti and Spier 1993). Robustness? Does debt really make you tough? Robustness to other competition games? Not much. Debt might commit you to be soft, i.e., help collusion (Glazer 1994). Commitment? Role of debt: Commit shareholders (ex-ante) to an ex-post inefficient reaction function. Renegotiation? Secret recontracting? What kind of firm? Same problems as usual. Why is management aligned with shareholders? Management may try to avoid default. Excessively conservative.

55 Robustness Important that quantity implies the other firm wants to quantity. Suppose that you are trying to deter entry, then if you are competing in prices, debt hurts you. Not robust to small default costs Also, one can design managerial incentive schemes to get rid of this effect.

56 PREDATION Old theories Cash-rich firms drive cash-poor firms out of business by competing aggressively in the short run. Costly predatory strategies (e.g., predatory pricing) are compensated by increased profits following the prey s exit. Critique Why would investors terminate valuable firms? Why do rivals follow costly predatory strategies?

57 More recent theories Based on financial market frictions. Example: Predator tries to convince rivals (or their investors) that the continuation value is negative. Examples: Predator convinces investors that he (his rival) has low (high) costs. Predator builds a reputation for being aggressive. Two strands: Predation affects the prey s (perceived) investment opportunities; Predation affects the prey s ability to fund its investment opportunities.

58 Agency-Based Theory Bolton and Scharfstein (1990). Main idea: Outside finance involves agency problems. Cashflow drives investment. By reducing short-run cashflows, predation reduces investment. Main idea: Model The entrepreneur makes the repayments because of the threat of termination, i.e., exclusion from further credit. Assumption (key): Non-verifiable cash flows. This generates investment-cashflow correlation because investors will not want to lend in the last period. Assumption (simplifying): The investor has full bargaining power initially.

59 Optimal Contract Absent Predation Contract: Repay R L = 0 and be refinanced with probability β L. Repay R H and be refinanced with probability β H β L + β. The entrepreneur gets θx H willing to pay in continuation and is The investor s profit is: R H = β θx H. Π np = I (1 θ) β L I + θ [ β θx H β H I ] = I β L I + θ β [θx H I ]. Optimal Contract: R H = θx H. β = 1, i.e., β H = 1 and β L = 0. The investor s payoff is: Π np = θ 2 X H (1 θ)i.

60 Predation Firm 1 is financed internally. Firm 2 needs outside finance. Predation: At cost c, firm 1 can decrease firm 2 s θ by θ. If firm 2 exits, firm 1 s profit in second period increases by π. Assumption: Predation may be valuable, i.e., c Φ < 1. θ π Predation increases firm 2 s exit probability by θ β. Hence, firm 1 preys if and only if Remarks: ( β θ ) π > c or Φ < β. The contract minimizing agency problems within the firm (β H = 1 and β L = 0) maximizes the incentives to prey. Predation occurs even if observed (or anticipated) by all parties.

61 Accommodating Predation If firm 2 anticipates predation: The optimal financial contract is the same as before. The investor s profit is only Π p = Π np θ ( θx H I ) Predation-Proof Contract Assume for now that firm 2 s financial contract is observed by firm 1. Firm 2 can deter predation by reducing β, i.e., making continuation less sensitive to performance. Deep-pocket strategy: Keep β H = 1. Increase β L until β = Φ. Investors are softer on the firm. Shallow-pocket strategy Keep β L = 0. Decrease β H until β = Φ. Investors are tougher on the firm.

62 Optimal Predation-Proof Contract The entrepreneur is willing to pay: Investor s profit R H = β θx H = Φ θx H. Π pp = I β L I + θ β [ θx H I ] = I β L I + θ Φ [θx H I ]. Hence, Shallow Pocket is optimal: β L = 0 and β H = Φ. Investor s profit Π pp = I + θ Φ (θx H I). Deter vs. Accommodate Deterrence is optimal if and only if Π pp > Π p, i.e., I + θ Φ (θx H I) > I + (θ θ ) (θx H I) This can be written as: θ Φ > θ θ.

63 Comments Remark 1: entry barrier. The predation threat can constitute an Cash poor firms will enter the market if and only if I + max{θφ; θ θ }(θx H I) > 0. More restrictive than absent a predation threat: I + θ(θx H I) > 0. Remark 2: If contracts are not observable, they cannot deter predation. Given firm 1 s strategy (i.e., given θ or θ θ ), setting β H = 1 and β L = 0 is optimal. Firm 1 will always prey.

64 Implications: Competition depends on a firm s access to internal funds. May depend on cross-sectional variation in availability of internal funds. Competition can affect internal incentive problems. Competitive threats limit the extent to which access to capital depends on performance. Important point in optimal capital structure checklist: Do competitors have deep pockets?

65 Signal Jamming Theory Fudenberg and Tirole (1986). Main idea: Investors observe signals about the firm s profitability. Incentives for rivals to distort the signals. Maybe true even if investors are not fooled in equilibrium.

66 Model At t = 1, 2, a firm generates i.i.d. cashflows X t { ; + }. Distribution h {h B, h G } with ν Pr [h = h G ] with : + X h G(X) dx > 0 > + X h B(X) dx. Assumption: Monotone Likelihood Ratio Property (MLRP): X h G (X) > 0. h B (X)

67 No Predation if Optimal policy: Terminate the firm at t = 1 if and only X 1 < ˆX. Predation A rival can secretly incurs a (tiny) cost so that: X 1 X 1 X. If the firm exits at t = 1, the rival gains π.

68 Equilibrium? If the investors anticipate no predation: They mistakenly liquidate if ˆX X < X 1 X < ˆX. If predation is not anticipated, there will be predation. Not an equilibrium. If the investors anticipate predation: Absent predation, investors will mistakenly continue if NOTE ˆX X < X 1 < ˆX. If predation is anticipated, there will be predation. This is an equilibrium. Predation does not fool the investors (i.e., they take the same decisions as without predation). Not general: Here predation does not affect the information content of X 1.

69 Comments BS and FT models are based on investment-cashflow correlation. In FT, the correlation is between cashflows and investment opportunities. In BS, the correlation is between cashflows and investment capacity. In FT, rivals would jam any observable variable a priori correlated with investment opportunities. In BS, rivals need to distort cash-flows. In BS, predation affects (only) cash-poor firms. In FT, it affects cash-poor firms only in so far as they need to raise funds from investors who are less informed than they are.