TOPICS
(1) Product Market Competition
(2) Earnings Manipulation
8th set of transparencies for ToCF
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CORPORATE FINANCE IN INDUSTRIAL CONTEXT:
THE FIRM AND ITS SUPPLIERS AND COMPETITORS
Corporate
finance
Borrowing level & structure.
 Collateral pledging.
 Allocation of control rights.
 Liquidity.
 Etc.
Industrial
organization
 Horizontal:
product market
competition
 Vertical:
supply chain
Questions
(1) Does competition facilitate or hinder financing?
(2) Using the financial structure to impact product market
competition.
(3) Using the financial structure to influence contracts with third
parties.
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(1)
COMPETITION AND FINANCING
(a) Basics: profit destruction and benchmarking effects.
2 identical firms, i=1,2.
must develop a new technology to enter / serve market
profit: = M if only firm to succeed,
 D if both firms succeed,
 0 if firm fails.
Fixed investment model. Net worth A<I each.
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Independent realizations
 Equilibrium in which both receive financing.
Reason: incentive constraint is still
since
Holmström sufficient statistic result implies that compensation
should not be linked to other firm’s realization.
 Equilibria in which one firm receives financing.
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Benchmarking: correlated realizations
Assume
perfect correlation conditional on efforts
infinite risk aversion at zero rather than limited
liability.
Both entering and behaving in equilibrium if
So if
then competition may facilitate financing.
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(b) Industry influence on financial structure /corporate
governance : Aghion-Dewatripont-Rey.
Basic points:
a) One firm’s financial structure or corporate governance
depends on its rivals’ choice in the matter.
b) The quest for pledgeable income may make these
choices strategic complements when they otherwise
(i.e., in terms of NPV) would be strategic substitutes:
More discipline in rival firm lowers pledgeable income
and calls for more discipline to satisfy investors.
Choice can be (depending on application).
a refocusing on line of business,
 high-powered monitoring, vertical integration,
 allocation of control rights,...
anything that a) disciplines manager and makes the
firm more competitive in market.
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Simple control right version:
Previous model except that entrepreneur can give control
right to investors. (Undescribable) action taken at interim
stage raises probability of success by (from
to
or from
to
). Imposes nonmonetary cost on
insiders
Thus action raises investor value, but decreases value overall.
Investors will take the action if receive control right (bear
none of private cost). Entrepreneur will not take action if
retains control (bears entire cost, receives only part of
benefit.
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Look at equilibria in which both firms receive financing
Equilibrium in which entrepreneurs retain control rights
(ADR call this the “shirking region”).
Equilibrium in which entrepreneurs surrender control rights
and
Note:
uniform shift implies incentive constraint
unchanged:
ADR call this the “bonding region”.
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Corporate governance decisions are:
strategic substitutes from NPV perspective:
where
strategic complements from pledgeable income perspective:
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COMMITMENT TO BE TOUGH: BRANDER-LEWIS (1986)
Variant of previous model.
Suppose firm 1 chooses corporate governance before firm 2.
Then firm 1 may choose to be very competitive in order to
deter entry (financing of firm 2)
Brander-Lewis a bit different (Cournot :
Issues debt. Creates a limited liability effect
“Stackelberg” leadership.)
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(2)
COMMITTING THROUGH THE FINANCIAL
STRUCTURE
PRELIMINARIES:
IO: McGee vs Telser
(a) SIMPLE MINDED LONG-PURSE STORY
[Fudenberg-Tirole 1985]
One firm has long purse (self-financed), other is financially
weak.
At date 0, financially weak firm is self-financed.
Date-0 profit will be date-1 net worth/equity.
Rival in market can take costly action (predation) that
reduces both firms’ date-0 profits. In particular, weak firm’s
date-0 profit falls from A to a<A.
Rival wants to prey if date-0 cost of predation smaller than
(assuming no discounting between periods).
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(a) STRATEGIC SECURITY DESIGN: BOLTONSCHARFSTEIN 1990
Basic points:
Financially weak firm can reduce occurrence of predation
through long-term contracting.
Long-term contracts that protect against predation are often
renegotiation proof.
Tension between minimizing agency problems and
minimizing rival’s incentive to prey.
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Assumptions:
Two identical periods, except that at date 0:
 private benefit of misbehaving B0 (not crucial),
 strong firm can prey at date 0 (no incentive to prey at
date 1). Predation results in zero profit at date 0 for
both.
Predation not observed by investors.
Weak firm: probabilities
success and failure.
and
of refinancing in case of
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 Assume
(reinvestment is desirable) and
(dearth of pledgeable income)
 Rent
at date 1 if reinvestment
note: more generally
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Optimal contract:
Predation deterrence (strong firm)
Date-0 incentives (weak firm)
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Weak firm’s NPV (in the absence of predation)
would like
but not incentive compatible.
On the other hand, (PD) requires
not too large.
 Either
and sufficiently large. Interpretation:
credit line. “Deep-pocket strategy”.
 Or bring down and
“Shallow-pocket strategy”:
low. Depends on initial wealth.
Renegotiation proof (entrepreneur likes continuation,
investors don’t).
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Empirical work
Weakness measured by high leverage
Chevalier (AER 95, JoF 95), Chevalier-Scharfstein
(AER 96).
 Supermarket industry. Entry and expansion of non-
LBO firms more likely in markets with LBO firms.
 Cyclical behavior of supermarket pricing.
Zingales (JoF 98). Trucking industry (average reduces
probability that firm survives an increase in competition.
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(3)
COMMITTING VIS-A-VIS SUPPLIERS OR
CUSTOMERS
Papers on debt as a commitment to be a tough bargainer:
Perotti-Spier, Spiegel (JEMS 96), Spiegel-Spulber (RJE 94),
Bronars-Deer (QJE 91),..
Firm/union; utility/regulator ; defense
contractor/government; incumbent management- raider;...
Several possible versions:
 “Soft budget constraint” (not usual one): lack of
liquidity.
 “Debt oberhang” version.
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Example: Assume
Optimal financing:
 issue senior debt
to dispersed
bondholders (plus unanimity rule) : overleverage,
 consume
before bargaining stage.
Supplier forced to offer input at marginal cost (zero).
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Renegotiation proofness issue.
Transaction costs (here).
Alternatives:
 Caillaud-Jullien-Picard (Econometrica
95) on asymmetric information.
 Spier-Whinston (RJE 95) on reliance.
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MANIPULATION OF EARNINGS
Additional forms of moral hazard (gaming the incentive
system).
(1) Timing of income recognition (moving income
forward/backward).
(2) Risk management (increasing/decreasing risk).
Effort incentives
incentives are aligned along
intertemporal dimension,
 risk dimension.
Multitasking problem.
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(1)
INTERTEMPORAL MANIPULATIONS
Topical: 3G mobile, ENRON, Worldcom, etc.
Two categories of earnings management:
(a) Accounting methods (“cooking the books”, exploiting
flexibility in generally accepted
accounting principles)
 choice of reserves/provision for loan losses,
 choice of date at which sale is recorded,
 capitalize or expense maintenance and investment
costs,
 balance sheet window dressing (banks’ bad risks
transferred to nonconsolidated subsidiaries; lease backs:
sell HQ and lease it in order to realize capital gain),...
Cost (besides fooling investors): time spent by managers;
“bribes”; psychological cost?
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(b) Operating methods
 delay shipments or ask customers to take early delivery,
 delay/speed up maintenance, replacement of
inventories,
 run end-of-period sales,...
Cost (besides fooling investors): bad timing, overtime pay,
production disturbances,...
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MANAGERIAL “MYOPIA”:
THE INCENTIVE FOR POSTURING
Disciplining management: Adverse selection or moral hazard
considerations
may want to  fire/liquidate
 downsize,
 interfere.
at intermediate stage in case of bad performance/signals.
Instruments:
 takeovers,
 strong board,
 control rights (e.g., venture capital),
 limited liquidity (short term debt),
 vesting of stock options,...
Popular press, Porter 1992,...: “Anglo-Saxon short termism”.
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Model
[Literature: Stein QJE 89. Related literature on second sourcing in
regulation/procurement, e.g., Laffont-Tirole RJE 88.]
Fixed investment model.
New ingredients:  can liquidate/replace manager at
intermediate stage,
 learning about manager’s ability.
Timing:
Example:
replace manager by new, unknown one.
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Assumptions
Entrepreneur would like to always keep her job:
But guaranteed tenure does not generate enough pledgeable
income:
while:
In the absence of manipulation, liquidate with probability
when bad signal:
note:
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Manipulation
Entrepreneur can generate signal
for sure by (secretly)
manipulating earnings.” Cost: probability of success falls
uniformly by
Let
and
denote the probabilities of continuation for
signal r and q.
If entrepreneur does not know signal when deciding whether
to manipulate, the condition for no manipulation (NM) is:
or
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OTHER FORMS OF POSTURING
(1) Risk preferences and career concerns
Back to Diamond 1984 model. Two projects A, B per
period, two periods. Entrepreneur has no responsiveness
to monetary incentives. Private benefit
p unknown (r with probability
per period
with probability
).
Keeps job at date 2 if and only if.
chooses independent or perfectly correlated projects.
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Let
denote posterior probability conditional on one success and
independence.
If
wants to take risk (correlated projects).
If
plays conservatively (independent projects).
“Gambling for resurrection”.
Chevalier-Ellison JPE 97: risk taking by mutual funds.
Poor performance in first three quarters:
gamble for resurrection.
Good performance in first three quarters:
conservative.
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(2) Herding behavior
Scharfstein-Stein 90
 God and bad managers (they don’t know).
 Good managers get an informative signal (the same
one).
Hence incentive to herd (possible choice of an inefficient
investment).
Countervailing forces
 Profit incentives.
 Debt and limited liability.
 Superstar effects.
 Creativity is valued talent.
See also Zwiebel JPE 95 on benchmarking.
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FOSD and SOSD moral hazard
Bester-Helwig 1987 (see also Alger 2000).
Induce effort (FOSD)
reward in upper tail (“stock
option”).
Multitasking problem: encourages risk taking.
Fixed investment model
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(ii) Agency cost:
 Investors can control R

Substitute p
FOC:
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Moral hazard
(i) No agency cost: max NPV =
Pledgeable income condition
Hence
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Results
(1)
(2)
(3) Pure debt contract is not optimal
wants some sharing at the margin: 2nd order loss/1st
order gain.
(4) Pure equity contract is not optimal
(5) Optimal contract: mixture:
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