Working Paper: NBER ID: w30841
Authors: Hui Chen; Winston Wei Dou; Hongye Guo; Yan Ji
Abstract: Firms tend to compete more aggressively in financial distress; this intensified competition, in turn, reduces profit margins, pushing themselves further into distress and adversely affecting their industry peers. To study such feedback and contagion effects, we incorporate strategic competition into a dynamic model with long-term defaultable debt, exploring various peer interactions like predation and price war. The feedback effect represents a novel source of financial distress costs associated with leverage, which helps explain the negative profitability-leverage relation across industries. Owing to the contagion effect, firms’ optimal leverage is often excessively high from an industry perspective, undermining the industry's financial stability.
Keywords: financial distress; competition; profit margins; contagion effects; capital structure
JEL Codes: C73; D43; G12; L13; O33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased competition due to financial distress (G33) | Reduced profit margins (L11) |
| Reduced profit margins (L11) | Increased likelihood of further financial distress (G33) |
| Increased competition due to financial distress (G33) | Increased likelihood of further financial distress (G33) |
| Reduced profit margins (L11) | Financial distress (G33) |
| Financial distress (G33) | Increased competition (L13) |