Financial Contracting when Rivals may Turn Nasty

This paper develops a principal-agent model of financial contracting in which optimal contracts resemble a combination of debt and equity. When defaulting on debt, the firm is punished by disruption of external funding. Such contracts however, invite rivals to compete more aggressively to increase the likelihood of default. The firm will respond to the threat of predation, by choosing a less leveraged capital structure, even though this will aggravate incentive problems. In contrast to the literature on debt as a device of strategic commitment, this result supports the common presumption that equity can enhance the firm's competitiveness in the product market.