Debt and Product Market Fragility

Abstract

Liquidation of a supplier of durable goods can be costly for its customers because it frequently undermines the smooth supply of after-sales service and spare parts or makes it more costly. This paper studies the interplay between capital structure and product pricing strategy when liquidation imposes costs on customers. I develop a model which illustrates that highly leveraged firms can enter a vicious circle in which financial distress and sales drops are re-enforcing. Multiple equilibria can arise. There exists a "good" equilibrium in which consumers buy and the firm is in good financial shape. However, when agency problems between investors and managers are severe, there is also "bad" equilibrium: consumers turn away from the vendor, the market collapses, and the firm goes bankrupt. Moreover, the "good" equilibrium is highly fragile in that a small shock to the firm's profits can trigger a spiral of sales drops. I show that the firm can avoid the "bad" equilibrium by cutting prices and reducing leverage.