Cost of Debt for Companies - The Influence of the Competitive Environment
Philip Valta empirically shows that the cost of bank debt is higher for firms that operate in competitive product markets. How can you explain this relationship between product markets and financial markets?
"Firms do not operate in isolation. They are in constant strategic interaction with other firms, struggling for customers andmarket shares," explains Philip Valta. "While some firms have the luxury of operating in less competitive productmarkets, others face severe competition." This competition affects their operating decisions, financial health, and investment strategies. "While recent evidence supports the view that the intensity of competition has important implications for firms' cash flows and stock returns, the effect of competition on the pricing of debt has so far remained unclear. This lack of evidence is surprising," notes Valta. "Debt is the dominant source of external finance and is crucial for firms' operating flexibility and for the financing of real investment activities." How does market competition affect the pricing of bank loans?
Several factors can explain why the cost of bank debt depends on the firm's competitive environment. The first of which is default risk (late payment by suppliers and credit companies). Firms with a higher default risk typically pay higher rates for their loans. "Since competition reduces pledgeable income and increases cash flow risk, it could also increase firms' default risk. Moreover, firms constantly face a competitive threat from their rivals. For instance, financially strong firms could adopt aggressive competitive strategies that can significantly increase the default risk of incumbent firms (Bolton and Scharfstein, 1990)," explains Valta. "Alternatively, if firms cannot fully exploit their investment opportunities, they risk losing these opportunities and market share to rivals. In both of these scenarios, the intensity of competition could increase the likelihood that firms default on their interest payments."
Asset liquidation value (used notably to assess the value of a company) is another factor that can explain the relationship between the cost of debt andmarket competition. "When contracts are incomplete and transaction costs exist, liquidation values are of central importance for the pricing of debt contracts," says Valta. "Higher liquidation values allow firms to obtain lower rates for their loans." However, the liquidation value depends on potential buyers as well as the specificity and the liquidity of assets. "When industries experience high asset illiquidity [the case in certain heavy industry sectors], potential buyersmay not be able to acquire a defaulted firm's assets. These assets would then trade at a discount compared to the value in best use. Fierce competition couldmagnify this fire sales effect and depress liquidation values evenmore,which in turn would affect the cost of debt financing."
The cost of debt is systematically higher for firms in highly competitive markets.
LARGE VARIATIONS IN THE COST OF DEBT
Valta's empirical analysis of a sample ofmore than 2,000 firms supports his hypotheses. By evaluating 7,425 bank loans, he proves that the cost of debt is systematically higher for firms in highly competitive markets.He also shows that this effect is even greater when the borrowing firm has competitors in good financial health, a high level of strategic interactions with these competitors, and when it operates in a sector where assets are illiquid or very specific. "Specifically, the effect of competition on spreads is two to four times as large in illiquid and asset specificmarkets as inliquidmarkets," says the researcher.
LINKAGES TO CONSIDER
Valta does not explore the mechanisms by which competition affects the cost of debt. However, the results suggest that characteristics relating to firms' default risk, investment opportunities, and liquidation value of their assets play an important role in explaining that link. "Overall, the results emphasize the importance of taking into account the linkages between product and financial markets." And while he has yet to study how firms should adjust their financing based on the competitive environment, he says that it "may be an important determinant of a firm's choice to issue equity, bank debt, or public debt."
Based on an interview with Philip Valta and the article "Competition and the Cost of Debt", Journal of Financial Economics, September 2012, vol. 105, n° 3, pp. 661-682.
APPLICATIONS FOR BUSINESSES
While Valta's work has yet to examine the link between the intensity of market competition and firms' investment and financing decisions, it does provide useful insights for leaders. In particular, it emphasizes the need for firms to take into account their environment and its potential impact on the cost of debt contracts to better adapt their financing strategy.
• Firms should consider whether they operate in a competitive market, a monopoly, or an oligopoly to determine if they can diversify to a less competitive market
• If firms operate in highly competitive markets, leaders may try to limit their use of debt by finding other ways to raise capital.
Valta conducted an empirical analysis using a large sample of loan contracts from publicly traded U.S. firms over the years 1997 to 2007 (7,425 loans for 2,283 distinct firms covering 170 referenced by the American Standard Industrial Classification, SIC) to study the effect of competitive markets on interest rates offered to firms.