research@hec - Issue #22 - (Page II)

Cost of Debt for Companies research Philip Valta The Influence of the Competitive Environment “Firms do not operate in isolation. They are in constant strategic interaction with other firms, struggling for customers and market shares,” explains Philip Valta. “While some firms have the luxury of operating in less competitive product markets, 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? 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? hec BIOGRAPHY Before joining HEC Paris in 2010, Philip Valta was a visiting research fellow at Duke University (Fuqua School of Business). His teaching and research interests focus mainly on corporate finance and more specifically the effects of competition on the cost of debt. He holds a PhD in finance from the Ecole Polytechnique Fédérale de Lausanne and the Swiss Finance Institute. DEFAULT RISK 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.” LIQUIDATION VALUE 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 and market 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 buyers may 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 could magnify this fire sales effect and depress liquidation values even more, which in turn would affect the cost of debt financing.” II research@hec • August-September 2011 http://www.hec.edu/Faculty-and-Research/Faculty/VALTA

Table of Contents for the Digital Edition of research@hec - Issue #22

Cover & Contents
Cost of Debt for Companies: The Influence of the Competitive Environment
Private Equity Investors: As Boosters of Corporate Performance
Managing International Sales Teams: Impact of Cultural Performance Orientation
HEC PARIS nEWS

research@hec - Issue #22

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