Chapter 92
On Capital Structure and Entry Deterrence
Fathali Firoozi and Donald Lien
Abstract The theoretical literature on the link between
an incumbent firm’s capital structure (financial leverage,
debt/equity ratio) and entry into its product market is based
on two classes of arguments, the “limited liability” argu-
ments and the “deep pocket” arguments. However, these two
classes of arguments provide contradictory predictions. This
study provides a distinct strategic model of the link between
capital structure and entry that is capable of rationally pro-
ducing both of the existing contradictory predictions. The fo-
cus is on the role of beliefs and the cost of adjusting capital
structure, two of the factors that are absent in the existing
models. The beliefs may be exogenously given or endoge-
nized by a rational expectations criterion.
Keywords Market entry r Leverage r Game theory
92.1 Introduction
There is a substantial literature on the strategic role that a
firm’s capital structure (financial leverage, debt-equity ra-
tio) could play in its product markets. A small but signif-
icant subset of this literature has focused on the link be-
tween a firm’s capital structure and entry into its product
market. The seminal studies in this subset include Brander
and Lewis (1986) and Poitevin (1989). The arguments can
be classified into two classes with contradictory predictions.
One class, referred to as the “limited liability” arguments ini-
tially proposed by Brander and Lewis (1986), goes along
the following line. Since share-holders do not have priority
to debt-holders in case of bankruptcy, a financial restructur-
ing that amounts to a reduction in the firm’s debt/equity ra-
tio changes the debt-holder and share-holder structure in a
way that forces the firm to be less aggressive in its prod-
uct market and thus encourages entry. The second class,
F. Firoozi and D. Lien ()
Department of Economics, University of Texas at San Antonio,
San Antonio, TX, USA
e-mail: ffiroozi@utsa.edu; don.lien@utsa.edu
C.-F. Lee et al. (eds.), Handbook of Quantitative Finance and Risk Management,
DOI 10.1007/978-0-387-77117-5_92,  c Springer Science+Business Media, LLC 2010
referred to as the “deep pocket” arguments initially proposed
by Poitevin (1989), suggests the following. A reduction in
incumbent’s debt/equity ratio effectively increases the debt-
financing capability of the firm. Since capacity expansions
are often debt-financed, an entrant views the incumbent with
low debt/equity ratio as having financial strength to engage
in predatory expansion through debt financing if entry oc-
curs. Therefore, the stated leverage reduction has the effect
of discouraging entry, thus contradicting the prediction given
by the limited liability arguments. Clearly, the connection
between capital structure and market entry as well as the
predictions summarized above are not limited to domestic
competition. Similar issues arise in international entry con-
texts. In fact, the impact of capital structure on international
market entry by multinationals has recently received atten-
tion in international trade circles. Related studies include
Chao et al. (2002), Chao and Yu (1996, 2000), Marjit and
Mukherjee (1998, 2001), Mukherjee (2002), Patron (2007),
and Vishwasrao et al. (2007).
In this study we propose a distinct strategic link between
an incumbent firm’s capital structure and entry into its prod-
uct market. We purpose a strategic model that brings into a
two-period stochastic setting two distinct links. The first link
is between capital structure and capacity expansion based
on a number of studies in the financial literature, including
Stulz (1990), Harris and Raviv (1991), and Li and Li (1996).
The second link is the connection between capacity expan-
sion and entry deterrence based on a number of classic stud-
ies, including Spence (1977) and Dixit (1980). The proposed
unified model in this study has the novel feature of recon-
ciling the existing contradictory predictions advanced by the
limited liability arguments and the deep pocket arguments as
summarized above regarding the link between capital struc-
ture and entry. The results in the present study demonstrate
that the crucial factors that could generate the existing con-
tradictory results consist of the probabilistic beliefs held by
potential entrants regarding the impact of capital structure on
operational expansion as well as the cost of adjusting capital
structure to the incumbent. Further, we show that the stated
belief may be exogenous or completely endogenized by a
rational expectations criterion. Needless to say the results
1381
1382
in the present study are directly applicable in international
entry contexts as well, given that capital structure plays a role
in determining the ability of an incumbent domestic firm to
expand.
The basic components of the model are constructed
in Sect. 92.2. Its equilibrium is studied in Sect. 92.3. The
link between capital structure and entry is then studied in
Sect. 92.4 with a special focus on the role of beliefs. Some
concluding remarks appear in the last section.
92.2 The Setting
Consider an incumbent monopolist in the first period of a
two-period time span and a potential entrant in period 1 con-
templating entry in period 2. The potential entrant in period
1 is concerned about the incumbent’s cost structure in pe-
riod 2. This cost structure depends on whether the incumbent
maintains its current productive capacity or will expand in
period 2. If the entrant is certain that the incumbent will ex-
pand, then it will not enter. Although the entrant is uncertain
about such expansion by the incumbent, it can develop a ra-
tional probabilistic assessment regarding such an expansion.
Hence, the entrant has a probabilistic assessment in period 1,
referred to as the entrant’s belief and denoted by ˇ, regarding
whether the incumbent will engage in capacity expansion in
period 2 if entry occurs. It is well known that a low leverage
(low debt/equity ratio) is often an essential prerequisite for
subsequent expansion, consistent with the observation that
capacity expansions are often debt-financed. For instance, the
studies of Stulz (1990), Harris and Raviv (1991), and Li and
Li (1996) have suggested that financial leverage is negatively
correlated with subsequent undertaking of growth and invest-
ment opportunities. This literature shows that low leverage is
often an essential component for subsequent expansion. As
such, the stated probabilistic belief depends on the incum-
bent’s capital structure (financial leverage or debt/equity ra-
tio) in period 1, information that is assumed to be publicly
available, thus observable by the potential entrant. Further,
as will be shown in Sect. 92.3, the functional form of the
connection between the entrant’s belief and the incumbent’s
capital structure may be rather general and exogenous or en-
dogenized by a usual expectations criterion.
A class of games often referred to as dynamic games of
incomplete information has a distinctive feature of incorpo-
rating beliefs (Aumann and Hart 1994). We now characterize
a context within this class. Typical models in the stated gen-
eral class are by nature interactive, dynamic, and stochastic,
thus require certain stylized set-ups for tractability. There-
fore, a number of additional assumptions must be made. We
construct a setting that reflects the essential features for this
study and avoids unnecessary complications.
F. Firoozi and D. Lien
At the start of period 1 and in the absence of any concern
about entry or expansion, the incumbent has implemented
an optimal capital structure and carries the physical produc-
tion scale or capacity K. The incumbent’s production is such
that the marginal cost is partially and inversely related to its
production scale or capacity. In the sense that an innovation
induced increase in scale or capacity will reduce unit costs,
investment in capacity can be equivalently viewed as invest-
ment in innovation in our setting. Therefore, given that the
incumbent’s current capacity is represented by K, a rise in
K reflects investment in innovation that yields lower per unit
costs for the incumbent.
In period 1, the potential entrant envisions two possibili-
ties for the capacity status of the incumbent in period 2: the
present capacity K or the expanded capacity K, so K < K.
The potential entrant is uncertain about whether the incum-
bent will continue with the present capacity K in period 2
or will have the expanded capacity K. Further, the potential
entrant must finalize its entry decision in period 1 before the
incumbent has manifested its capacity for period 2. As such,
the entrant will develop a likelihood of innovation induced
capacity expansion by the incumbent that depends on the in-
cumbent’s financial positioning in period 1. This likelihood,
which is the potential entrant’s belief, will be characterized
shortly. As will be shown, the incumbent has rational incen-
tive to discourage entry. Thus, when faced with a possibil-
ity of entry, the incumbent maintains a capital structure that
could accommodate expansion. A crucial observation that
will be incorporated shortly is that financial positioning for
innovation induced expansion is costly to the incumbent. No
presumption is made about the length of each period except
that the end of period 1 is marked by a common observa-
tion that either the potential entrant has finalized the decision
to enter in period 2 or the threat of entry is terminated.
We next specify the market demand, costs, and the nature
of interaction if entry occurs in period 2. Throughout, we
assume that the output is the numeraire. As for the market
demand for the output in period 2, the following structure is
assumed:
X D a  bP (92.1)
where a > 0 represents the market size, b > 0 is the price
sensitivity of demand, X is the total demand for the output,
and P is the market price. In further characterization of the
incumbent, we bypass the usual control and agency issues by
assuming owner-manager unity. This unity also allows us not
to distinguish between financial and operational profits and
reflect the two in an overall profit function.
Any reduction in financial leverage (reduction in
debt/equity ratio) is treated as a costly investment in the
present study for the following reason. In the case of leverage
reduction by issuing new equity, the stated adjustment cost is
in accord with the literature that has shown equity issuance
92 On Capital Structure and Entry Deterrence
will generally carry an adverse effect on the firm’s valuation
by financial markets. References include Myers and Majluf
(1984) and Asquith and Mullins (1986) who showed that an-
nouncement of equity issue and the firm’s share prices are
negatively correlated. Further, we assume that the cost of
leverage reduction in period 1 is distributed as cost in periods
1 and 2 in accordance with a common practice that distributes
an investment cost over current and future periods when the
benefits are expected to be realized. This practice is often
adopted to avoid misleading profit report for any period.
To reflect the above assumptions and specifications, we
incorporate the incumbent’s financial leverage (L) into its
overall profit function via costs. Furthermore, we adopt the
usual assumption that the incumbent’s production capacity
(K) is inversely related to its marginal cost so that an inno-
vation induced increase in capacity as reflected by a rise in
K will reduce its marginal cost. All of the stated cost charac-
teristics are incorporated by adopting the following marginal
cost function for period 2, which reflects both financial and
operational costs to the incumbent in period 2:
A.L; K/ D   L  K (92.2)
where  > 0 is a constant,  > 0 reflects the cost effect of
a leverage reduction,  > 0 represents the reduction in pro-
duction cost associated with an innovation induced capacity
expansion, L is the incumbent’s financial leverage (capital
structure, debt/equity ratio) in period 1, and K is the incum-
bent’s capacity in period 2. As elaborated earlier, leverage
reduction in period 1 has cost effects that distribute over peri-
ods 1 and 2, which is reflected by the second term in Equation
(92.2). Since our focus is on the impact of L and K, it suf-
fices to assume a constant marginal cost in relation to output.
These aspects also allow a further simplification by assuming
that the conventional fixed costs are zero so that the marginal
cost reflects the average cost as well. To illustrate in a con-
ventional cost-output diagram, each period’s average cost
(AC) and marginal cost (MC) schedules may be viewed as
coinciding horizontal lines that shift with changes in L or K.
This line is initially shifted up when the leverage L is reduced
as determined by the leverage reduction cost coefficient (),
and shifted down when the capacity K is increased as de-
termined by the capacity coefficient ( ). A smaller value for
 implies a smaller financial cost associated with any lever-
age reduction. A larger value for  reflects a larger cost re-
duction emerging from any innovation induced expansion of
capacity.
As for the potential entrant, in the case of entry in pe-
riod 2, the entrant will have a given marginal cost parameter
c > 0. As in the case of the incumbent, we assume zero con-
ventional fixed costs so that the cost parameter (c) represents
both the marginal cost and average cost to the potential en-
trant in the case of entry.
1383
Beliefs. We now specify the potential entrant’s belief as
defined earlier in general form. From the potential entrant’s
perspective in period 1, the likelihood that the incumbent will
adopt the expanded innovation induced capacity K in pe-
riod 2 is a function of the incumbent’s financial leverage in
period 1. This likelihood reflects the potential entrant’s belief
and is defined by:
ˇ.L/ D ProbŒK D KjL (92.3)
so ˇ.L/ is the potential entrant’s probability assessment that
the incumbent will adopt the expanded capacity K in pe-
riod 2, given the incumbent’s financial leverage L in period
1. Thus:
1  ˇ.L/ D Prob ŒK D K jL (92.4)
is the likelihood that the expansion will not occur. We assume
that a smaller L(smaller debt/equity ratio) corresponds to a
larger likelihood of expansion, so
dˇ d
D Prob ŒK D K jL  0 (92.5)
dL dL
As will be shown, the assumption dˇ=dL  0 alone is not
sufficient to guarantee that a reduction in debt/equity ratio
(dL < 0) will discourage entry. In fact, the extent of the be-
lief response (dˇ > 0) by the potential entrant as well as
the cost of the leverage reduction for the incumbent will be
the crucial determining factors in the interactive equilibrium.
It is clear that different potential entrants may assign differ-
ent exogenous functional forms and different slopes to ˇ.L/,
depending on factors such as their individual prior knowl-
edge, perceptions, and characters. Even if beliefs within an
industry are uniformly determined by the industry character-
istics, cross-industry beliefs may well be different. As will
be shown in Sect. 92.3, the functional form of ˇ.L/ may be
endogenized by a rational expectations criterion.
As stated, the incumbent will have two possible cost
schemes in period 2, one with the existing capacity K and
one with the innovation induced expanded capacity K. These
two cost schemes are specified via (92.2) as:
A.L; K/ D   L   K (92.6)
A.L; K/ D   L   K (92.7)
If follows from K < K that A < A. From the potential en-
trant’s perspective in period 1, the incumbent in period 2 will
have the low cost A (high capacity K ) with the probability ˇ
and the high cost A (low capacity K) with the probability
1  ˇ. It is clear that:
dA d AN
D D  < 0 (92.8)
dL dL
reflecting the assertion justified prior to Equation (92.2) that
a leverage reduction (dL < 0) has adverse cost effect.
1384
92.3 Equilibrium
Utilizing the setting in the last section and a usual interac-
tion scheme, we first develop the reaction functions for the
subgame that involves entry and then study the equilibrium.
Further, we show that the belief function ˇ.L/ may be endog-
enized by a rational expectations mechanism. A determinant
of entry decision is the nature of post-entry interaction be-
tween the entrant and the incumbent. We assume a Cournot
interaction. Let Xe and Xm be the Cournot equilibrium out-
put levels for the entrant and the incumbent in period 2 in the
case of entry. Utilizing Equation (92.1), the market price is
given by:
P D .1=b/.a  X / D .1=b/Œa  .Xm C Xe / (92.9)
The incumbent’s profit function …m is then defined, leading
to the problem:
Max …m
Xm
…m D PXm  AXm
D .1=b/Œa  .Xm C Xe / Xm  A.L; K/Xm (92.10)
where A.L; K/ is defined in Equation (92.2). The first order
condition for the maximization of …m over Xm generates the
solution:
Xm D .1=2/Œa  bA.L; K/  Xe (92.11)
The second derivative of …m is 2=b < 0, which shows
its concavity in Xm , thus satisfying the second order condi-
tion for maximum. Equations (92.9)–(92.11) show that the
incumbent will enjoy higher values for its market price, prof-
its, and output in the absence of the entrant (Xe D 0). This
demonstrates the existence of a rational motivation for the in-
cumbent to engage in entry deterrence activities. For the two
possible capacities and cost schemes AN and A as specified
in Equations (92.6) and (92.7), the incumbent’s two possible
reaction functions are specified via Equation (92.11) as:
X m .Xe / D .1=2/Œa  bA  Xe (92.12)
X m .Xe / D .1=2/Œa  bA  Xe (92.13)
where X m is the low capacity (high cost) output and X m is
the high capacity (low cost) output of the incumbent. It fol-
lows from A < A that X m < X m . The incumbent will choose
X m over X m if the profit associated with K is larger than that
associated with K, and vice versa.
As for the potential entrant, the post-entry profit function
under complete information is:
…e D PXe  cXe D .1=b/Œa  .Xm C Xe / Xe  cXe
D .1=b/Œa  bc  Xm  Xe Xe (92.14)
F. Firoozi and D. Lien
where the second equality follows from Equation (92.9). But
the potential entrant is uncertain about the incumbent’s reac-
tion function Xm . This uncertainty emerges from the poten-
tial entrant’s incomplete information about the incumbent’s
capacity in period 2. After observing the incumbent’s lever-
age .L/ in period 1, the potential entrant utilizes own belief
ˇ.L/ and the incumbent’s possible reactions in Equations
(92.12) and (92.13) to maximize the expectation of own
profit in Equation (92.14), leading to the problem profit:
Max E…e
Xe
E…e D ˇ…e .K/ C .1  ˇ/…e .K/
˚ 
D ˇ.L/  .1=b/Œa  bc  X m  Xe Xe
CŒ1  ˇ.L/  f.1=b/Œa  bc  X m  Xe Xe g
˚ 
D .1=b/ .a  bc  Xe /  ˇ.L/X m  Œ1  ˇ.L/ X m Xe
(92.15)
Here we assume risk neutrality so that maximization of ex-
pected profit and maximization of expected utility of profit
generate the same results. The maximization of E…e over
Xe leads to the first order condition:
.a  bc  2Xe /  ˇX m  .1  ˇ/X m D 0 (92.16)
The second derivative of E…e is 2=b < 0, which shows its
concavity in Xe . The potential entrant’s reaction function is
then the solution to Equation (92.16):
Xe .X m ; X m / D .1=2/Œ.a  bc/  ˇX m  .1  ˇ/X m
(92.17)
The equilibrium output values for the two players are the
simultaneous solutions to the three reaction functions in
Equations (92.12), (92.13), and (92.17) that can be written
in the matrix form:
2 32 3 2 3
12 0 Xe a  bA
41 0 2 5 4 X m 5 D 4 a  bA 5 (92.18)
2 ˇ .1  ˇ/ Xm a  bc
The solution to Equation (92.18) identifies the post-entry in-
teractive optimal output values, which are given by:
Xe .L/ D .1=3/Œ.a  2bc/ C ˇbA C .1  ˇ/bA (92.19)
X m .L/ D .1=6/Œ2.a C bc/  .3 C ˇ/bA  .1  ˇ/bA
(92.20)
X m .L/ D .1=6/Œ2.a C bc/  ˇbA  .4  ˇ/bA (92.21)
Here ˇ , A , and A are functions of L as specified in the last
section.
92 On Capital Structure and Entry Deterrence 1385

Before proceeding to a characterization of the link bet-
ween the incumbent’s leverage and entry, some intuitive ob-
servations are noted in the results Equations (92.19)–(92.21).
It is clear that a participant’s optimal output is inversely re-
lated to its own marginal cost and directly related to the
other participant’s marginal cost; a rise in the incumbent’s
costs (A or A) decreases the incumbent’s optimal output and
Utilizing the equilibrium solutions (Equations (92.19)–
(92.21)), we can evaluate the incumbent’s capacity and pro-
duction choices. Specifically, X m (the incumbent’s optimal
output under the expanded capacity) is chosen over X m if and
only if the profit under expansion exceeds the profit without
expansion; that is,

1  
increases the potential entrant’s post-entry optimal output. a  X m  Xe X m  AX m  
Similarly, a rise in the potential entrant’s costs (c) decreases b

its post-entry optimal output and increases the incumbent’s 1

Œa  X m  Xe X m  AX m (92.22)
output. All optimal output values are directly related to the b
size of the market demand (a). The potential entrant’s belief
Utilizing Equations (92.19)–(92.21) and some algebraic ma-
(ˇ) about the incumbent’s expansion has a crucial impact not
nipulation, the above inequality reduces to:
only on its post-entry optimal output but on the incumbent’s
optimal output as well. "
a C bc b  
Since the potential entrant’s post-entry optimal output as   .K  K/  8  8L  5 K  3 K
3 12
specified in Equation (92.19) is a function of the incumbent’s
#
financial leverage in pre-entry period, the context may seem ˇ.L/b
to be one of signaling with the leverage serving as the sig- C .K  K/ (92.23)
6
nal for the incumbent. However, as stated in the last section,
the context as it stands is not one of signaling but one in the Thus, under the usual rational expectations criterion, the
more general class of dynamic games of incomplete informa- probability of capacity expansion is the likelihood of the
tion. In a typical game from the subclass of signaling, there above inequality; that is,
exists private information or information asymmetry, which
 
are clearly absent in the present context. But there are restric- a C bc b
tions that could reduce the present context to one of signal- ˇ.L/ D F .K  K/ 
3 12
ing. For instance, if we assume that the incumbent has private  
information that it will not engage in innovation induced ca- 8  8L5 K  3 K
pacity expansion in a post-entry game but intends to signal 
ˇ.L/b
otherwise via its leverage in period 1 to deter entry, the con- C .K  K/ (92.24)
6
text then would be one of signaling with the leverage serving
as the signal. In that case, the optimal post-entry output val- Therefore, a rational specification for ˇ.L/ in the present
ues would still be those specified by Equations (92.19) and context is the solution that emerges from Equation (92.24).
(92.21) above and one may proceed in the direction of de- Note that the differentiation of Equation (92.24) by the chain
signing optimal signal. However, for the present purpose of rule generates:
highlighting the role of beliefs in linking capital structure to
entry, a restriction of the context to one of signaling is not  
8b ˇ 0 .L/b
needed. ˇ .L/ D F fg .K  K/
0 0
C .K  K/
12 6
Rationalization of beliefs. We now show that the entrant’s
leading to the solution:
belief ˇ.L/ as defined earlier can in fact be endogenized
through a rationalization process. Suppose the expansion by  
F 0 fg .K  K/ 8b
the incumbent in period 2 requires a cost of , which is ˇ .L/ D
0

12
(92.25)
b
known in period 2 but is a random variable in period 1. Let 1  F fg
0  .K  K/2
2

F ./ denote the probability distribution of : 6

We have shown in Equation (92.5) that ˇ.L/ must satisfy

F .x/ D ProbŒ  x ˇ 0 .L/  0. Within the support of the density function F
1386
we have F 0 ¤ 0, thus ˇ 0 .L/ ¤ 0. Since the numerator in
Equation (92.25) above is nonnegative, the strict inequality
ˇ 0 .L/ < 0 holds if and only if the following condition holds:
A monotonicity condition. Our primary purpose is to high-
b
1  F 0 fg  2 .K  K/2 < 0 (92.26)
6
For example, if the expansion cost is uniformly distributed
over Œ0 ; 1 , then F 0 fg D 1=.1  0 / and the parametric
condition in Equation (92.26) for ˇ 0 .L/ < 0 becomes:
6 .1  0 / < b 2 .K  K/2 (92.27)
Thus, in the present context, the statement in Equation
(92.27) establishes a sufficient parametric condition for the
rationality of the belief that emerges from Equation (92.24).
92.4 Capital Structure and Entry Deterrence
The central issue of capital structure and entry deterrence can
now be closely studied. Recall the potential entrant’s post-
entry interactive optimal profit function stated in Equation
(92.15):
E…e D .1=b/Œ.a  bc  Xe /  ˇX m  .1  ˇ/X m Xe
(92.28)
Substitution of the output equilibria Equations (92.19)–
(92.21) into Equation (92.28) generates:
E…e .L/
h market size (a) and/or sufficiently large incumbent’s cost
D Œ1=.9b/ .a  2bc/2 C 2.1  ˇ/.a  2bc/bA
C ˇ.2  ˇ/.a  2bc/bA C ˇ.1  ˇ/.2  ˇ/b 2 AA
i
2 by the first order condition.
C ˇ 2 .1  ˇ/b 2 A C .1  ˇ/2 b 2 A2 (92.29)
where ˇ, A, and A are functions of L with dˇ=dL < 0,
d A=dL D d A=dL < 0 as specified in the last section.
Since the potential entrant’s decision on entry is determined
by its post-entry interactive optimal profits, a link between
the incumbent’s capital structure and entry is identified by
the slope dE…e =dL. However, the entrant’s post-entry profit
function as specified in Equation (92.29) is highly nonlin-
ear in L and even with adoption of a simple functional form
for ˇ.L/ a characterization of the slope dE…e =dL does not
seem to be a tractable task. One significant revelation at this
point is that for values for L where dE…e =dL > 0Œ< 0 ,
a decrease in the incumbent’s leverage discourages [encour-
ages] entry through a decrease (an increase) in the potential
F. Firoozi and D. Lien
entrant’s post-entry profits. Some intuitive explanations for
this result will be given shortly. The determinants of entry
and their roles are summarized in Equation (92.29).
light the role of beliefs in characterizing the link between
capital structure and entry deterrence. Therefore, for the
purpose of conducting further comparative static analysis
without getting nailed down right away by the stated com-
plexities in Equation (92.29), it suffices that we focus on the
case where the initial relationship between the potential en-
trant’s post-entry optimal output and its post-entry optimal
profit is monotonically increasing. Thus, changes that bring
a rise in optimal output will also bring a rise in optimal profit.
We now show that for this monotonicity condition to hold, it
suffices that initially the market size (a) and/or the incum-
bent’s cost (A) be sufficiently large. Since the monotonicity
of a random variable with respect to a parameter extends to
its expectation, the monotonicity condition regarding the po-
tential entrant’s profit function in Equation (92.14) extends
to the potential entrant’s expected profit function in Equation
(92.15). Thus, it suffices to work with the potential entrant’s
profit function in Equation (92.14). Substituting the incum-
bent’s reaction function Equation (92.11) for Xm in Equation
(92.14) generates:
 
1 1 1
…e D .1=b/ a  bc C bA  Xe Xe
2 2 2
Therefore,
 
d…e 1
D .1=b/ .a C bA/  .bc C Xe /
dXe 2
It follows that d…e =dXe > 0 holds for sufficiently large
(A). Note that dXe and d…e here are changes in optimal val-
ues initiated by a parametric change. At an optimum for a
given set of parametric values, the stated derivative is zero
Under the stated monotonicity condition, comparative
static results regarding the potential entrant’s optimal output
(Xe ) extend directly to those regarding the entrant’s optimal
profit (…e ). The potential entrant’s post-entry optimal output
as specified in Equation (92.19) can be written as:
Xe .L/ D .1=3/Œ.a  2bc/ C bA  ˇ b.A  A/ (92.30)
By the statements in Equations (92.6) and (92.7), b.AA/ D
b.K  K/ > 0, and with a use of Equation (92.6) for A,
Equation (92.30) reduces to:
h
Xe .L/ D .1=3/ .a  2bc C b  b K/
i
b.K  K/ˇ.L/  bL (92.31)
92 On Capital Structure and Entry Deterrence
The strategic and cost effects. It follows that a reduction in
leverage (L) by the incumbent in period 1 has two distinct
and opposing effects on the potential entrant’s post-entry op-
timal output in period 2 as reflected by the second term con-
taining ˇ.L/ and the third term containing L in Equation
(92.31). The second term, which will be referred to as the
strategic effect, works through the potential entrant’s belief.
Consider the case dˇ=dL < 0. Since b.K  K/ > 0, the
strategic effect of a reduction in the incumbent’s leverage re-
sults in a decrease in the potential entrant’s post-entry op-
timal output. This is due to the fact that an increase in the
potential entrant’s belief that the incumbent will adopt the
innovation induced expansion implies a higher likelihood of
a lower marginal cost for the incumbent and a lower post-
entry optimal output for the potential entrant. The extent
of the strategic effect is determined mainly by the potential
entrant’s belief (ˇ), the incumbent’s capacity savings coeffi-
cient ( ) as specified in Equation (92.2), and the expected ex-
pansion .K  K/. The third term in Equation (92.31), which
will be referred to as the cost effect, works mainly through
the incumbent’s financial cost parameter () associated with
a leverage reduction as specified in Equation (92.2). The cost
effect of a reduction in the incumbent’s leverage will in-
crease the potential entrant’s post-entry optimal output. As
discussed prior to and after Equation (92.2), a reduction in
the incumbent’s leverage involves a financial value cost for
the incumbent, which increases the incumbent’s marginal
cost and thus raises the potential entrant’s post-entry opti-
mal output. It is clear that the incumbent will benefit from
the strategic effect of reducing its leverage but it suffers from
the cost effect of doing so.
The fact that a leverage reduction entails a financial cost
that is incorporated into the interactive process raises the fol-
lowing case. If the potential entrant’s belief is not sufficiently
sensitive to the incumbent’s leverage, then a leverage reduc-
tion by the incumbent could in fact encourage entry via a
cost effect that overrides the strategic effect. The notion of
potential entrant’s belief sensitivity to leverage as defined
by jdˇ=dLj will play a crucial role in the following anal-
ysis of this issue. We consider the two cases associated with
dˇ=dL  0.
Case (i): dˇ=dL D 0. Consider the case where a reduction
in financial leverage by the incumbent has no impact on the
potential entrant’s likelihood assessment that the incumbent
will subsequently engage in innovation induced expansion.
Note that this extreme belief is rather irrational according
to the rational expectations criterion studied at the end of
the last section where the slope dˇ=dL is strictly negative.
1387
However, it serves as a benchmark for our analysis. If follows
from Equation (92.31) that:
dXe =dL D b < 0
Hence, by the monotonicity condition, d…e =dL < 0. It is
clear that in this case a leverage reduction by the incumbent
increases the entrant’s post-entry optimal output and profit,
thus encourages entry. A leverage reduction in this case has
only cost effect and its strategic effect is zero. A summary is
given below.
Proposition 1. Under the stated monotonicity condition and
in the case where initially there is no belief sensitivity to
leverage (d“=dL D 0), a reduction in financial leverage (re-
duction in debt/equity ratio) by the incumbent has no strate-
gic effect and its cost effect will encourage entry.
On a purely intuitive ground, the above result may be ex-
plained as follows. When the potential entrant pays close at-
tention to an incumbent’s cost and profitability reports but
pays no attention to the incumbent’s capital structure, then a
costly reduction in financial leverage by the incumbent could
in fact encourage entry, although the leverage reduction puts
the incumbent in a better financial position to engage in in-
novation induced expansion and predation if entry occurs.
The case where a leverage reduction has nonzero strategic
effect beside the cost effect and may discourage entry is dis-
cussed next.
Note that the rationalization of beliefs discussed earlier
involved the random cost parameter  with the probability
distribution F ./. In the special case where there is no uncer-
tainty so  assumes a certain value, F ./ is a constant with a
jump at the value of . It follows then from Equation (92.24)
that dˇ=dL D 0, hence the analysis and results summarized
in Proposition 1 above apply in the case where the parame-
ter  is deterministic.
Case (ii): dˇ=dL < 0. We now assume the potential en-
trant has some sensitivity to financial leverage as a tool of
expansion so that the belief sensitivity to leverage (jdˇ=dLj)
is nonzero. We analyze the strategic role of leverage in entry
deterrence in this case as follows. The adopted negative sign
here is consistent with the rational beliefs studied at the end
of the last section. We continue under the stated monotonic-
ity condition. Define G > 0 and H > 0 as follows:
G D .1=3/b.K  K/ (92.32)
H D .1=3/b (92.33)
1388 F. Firoozi and D. Lien

Then the potential entrant’s post-entry optimal output as setting its control variable; namely, its capital structure in the
specified in Equation (92.31) shows that: present setting, so that the entrant’s expected post-entry out-

put level Xe is reduced the level Xe0 . Thus, the entry-deterring
dXe dˇ financial leverage L O for the incumbent is the value of L that
D H  G (92.34)
dL dL generates Xe .L/ D Xe0 where Xe .L/ is given by Equation
(92.31) above. Define:
It follows from Equation (92.34) that the condition
dXe =dL > 0 is equivalent to: I D .1=3/Œa  2bc C b  b K  Xe0 (92.37)
dˇ H 
< D <0 (92.35) Under the case (ii) elaborated above, applying the defini-
dL G .K  K/ tions and results in Equations (92.32), (92.33), (92.37), and
(92.31) reduces the equality Xe .L/ D Xe0 to the following
The preceding condition is equivalent to:
equation in L:
ˇ ˇ
ˇ dˇ ˇ 
ˇ ˇ Gˇ.L/ C HL  I D 0
ˇ dL ˇ > .K  K/ (92.36) (92.38)

Thus the incumbent’s entry-deterring financial leverage is

Thus Equation (92.36) is a necessary and sufficient condi-
the solution LO to Equation (92.38). If the function on the
tion for dXe =dL > 0 and, by the monotonicity condition,
left side of Equation (92.38) is strictly monotonic in L, then
for d…e =dL > 0. If the entrant’s belief sensitivity to lever-
Equation (92.38) has a unique solution. But this function has
age (jdˇ=dLj) exceeds the lower bound specified on the right
the slope ŒG.dˇ=dL/ C H , which is negative by Equation
side of Equation (92.36), then the strategic effect of a lever-
(92.35), thus Equation (92.38) in fact has a unique entry-
age reduction by the incumbent exceeds its cost effect so that O Note that the incumbent’s fi-
deterring leverage solution L.
the potential entrant’s post-entry optimal output and profit
nancial leverage is not the only factor that can deter entry.
fall and entry is discouraged. The results are summarized in
Other factors that can bring the output criterion Xe D Xe0
the following proposition.
to hold in the present setting are those specified in the solu-
Proposition 2. Under the stated monotonicity condition, tion for Xe in Equation (92.31). For instance, a sufficiently
when the potential entrant’s belief sensitivity to leverage high marginal cost for the entrant as reflected by a suffi-
(jd“=dLj) exceeds the lower bound specified in Equation ciently high value for “c” in Equation (92.31) could in fact
(92.36), the strategic effect of a reduction in financial lever- reduce the entrant’s expected output Xe to the entry-deterring
age (reduction in debt/equity ratio) by the incumbent will level Xe0 .
exceed its cost effect so that the leverage reduction will dis-
courage entry. The stated bound is determined by the incum-
bent’s cost characteristics (;  ) and its expected expansion
.K  K/. The smaller is =Œ.K  K/ the larger is the like-
92.5 Conclusion
lihood that a lowering of leverage discourages entry.
The theoretical and empirical literature has not settled the
The above result further highlights the significance of
issue of how an incumbent’s capital structure (financial lever-
prior beliefs held by potential entrants in linking an incum-
age, debt/equity ratio) may affect entry into its product mar-
bent’s capital structure to entry deterrence. It also gives a
ket. There are two classes of existing theories that generate
strategic justification for certain behavior often manifested
opposing predictions, one based on the “deep pocket” argu-
by incumbents, including attempts to heighten the public
ments, and the other based on the “limited liability” argu-
expectation of their future capacity expansion (K), increase
ments. The focus of the present model has been on two of
their capacity savings coefficient (”), and decrease their fi-
the factors that are absent in the existing models of the stated
nancial cost coefficient (). As shown above, these changes
link; namely, the belief held by the potential entrant regard-
decrease the bound =Œ.K  K/ and thus increase the
ing the incumbent’s expansion, and the cost of adjusting cap-
likelihood that a lowering of financial leverage will discour-
ital structure to the incumbent. By incorporating these two
age entry.
factors into a distinct strategic link between an incumbent’s
An entry deterrence criterion. Suppose the entrant requires capital structure and entry into its product market, the study
that its post-entry production level exceeds the quantity Xe0 has presented a model that is capable of rationally produc-
in order to remain viable in the case of entry. Assuming that ing both of the opposing predictions in the existing litera-
the incumbent is aware of this minimal output requirement ture. The incorporated probabilistic belief, which is formed
by the entrant, entry-deterrence by the incumbent amounts to by the potential entrant and defined as a function of the in-
92 On Capital Structure and Entry Deterrence
cumbent’s capital structure (L), may be exogenous or com-
pletely endogenized by a rational criterion. Beside the belief,
another crucial factor in linking financial leverage to entry
appears to be the cost of leverage reduction incurred by the
incumbent.
When the potential entrants’ belief about the incumbent’s
innovation induced expansion has sufficiently high sensitiv-
ity to the incumbent’s capital structure, the prediction of the
model is that a reduction in the incumbent’s financial lever-
age (reduction in debt/equity ratio) will discourage entry. The
explanation here is that the positive strategic impact of reduc-
ing leverage overrides its cost effect for the incumbent so that
the net effect in equilibrium is to discourage entry through a
reduction in post-entry optimal output and profit for the po-
tential entrant. This justification is fundamentally different
from the one given by the existing “deep pocket” arguments
that suggest a reduction in incumbent’s debt/equity ratio ef-
fectively increases both the available cash and debt-financing
capability for the incumbent, thus discourages entry.
A distinctive aspect of the present setup is that it could
rationally explain both positive and negative correlations be-
tween capital structure and entry deterrence. When the po-
tential entrants’ belief has sufficiently low sensitivity to the
incumbent’s capital structure, then the strategic effect of a
reduction in leverage (reduction in debt/equity ratio) by the
incumbent is overridden by the cost of reducing the lever-
age, thus the leverage reduction could in fact encourage en-
try. The case may be elaborated further on intuitive grounds
as follows. When potential entrants pay close attention to an
incumbent’s current cost and profitability reports but not suf-
ficient attention to the incumbent’s capital structure, a costly
reduction in financial leverage by the incumbent could in
fact encourage entry, even under the condition that the lower
leverage financially puts the incumbent in a better strategic
position to engage in a subsequent competitive expansions
if entry occurs. This justification is very different from the
one given by the existing “limited liability” arguments that
are typically presented as follows. Since share-holders do not
have priority to debt-holders in case of bankruptcy, a reduc-
tion in incumbent’s debt/equity ratio changes the debt-holder
and share-holder structure in a way that forces the incumbent
to be less aggressive in its product market and thus encour-
ages entry.
The small body of empirical literature that exists on this
issue is inconclusive and has suggested both positive and
negative correlations between capital structure and entry with
theoretical justifications based on the deep pocket and lim-
ited liability arguments as elaborated above. Our study has
suggested an alternative rational model that closes the ex-
isting gap but introduces a new explanatory variable into
1389
the empirical specifications; namely, the belief held by the
entrants. Although this belief and its crucial role are now the-
oretically defined and rationalized, the empirical challenge
that remains is to find out how to measure or identify a proxy
for the belief variable. The study can also be extended in a
number of directions. For instance, a subsequent undertak-
ing could analyze the issue of entrant’s capital structure and
entry deterrence by incumbent. Another extension may study
the case where the incumbent and the entrant compete in the
formation of capital structure, each with the intention of in-
fluencing the other player’s response.
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