Firms choose their debt to equity (i.e., leverage) ratios to balance the benefit of borrowing against its cost; namely, to balance the tax advantages against the greater likelihood of financial distress. The degree of competition in product markets affects the relative importance of these costs and benefits, and therefore firms modify their capital structures depending on whether they operate in more or less competitive product markets. In a recent paper, J. Reboul and A. Toldrà-Simats study the strategic behavior of levered firms in a regulated (i.e., non-competitive), and a deregulated (i.e., competitive) market. More specifically, they use a sample of electricity-generating companies in 13 European countries that underwent deregulation. By collecting data for these companies during the regulated period and also after deregulation took place, the authors are able to compare the strategies of firms in a regulated and a deregulated environment.
The main finding is that levered large and small electricity firms adopted remarkably different strategies when deregulation occurred. After deregulation, leverage induced large firms to adopt aggressive output strategies. That is, large firms with more leverage invested more and increased their production. This strategy allowed large firms to increase their market shares. The giant French electricity producer EDF is a good example of this strategy, as the company spent about 19 billion euros to expand its capacity by acquiring smaller regional firms between 2001 and 2003. In contrast, leverage induced small firms to charge higher prices after deregulation. This strategy allowed small firms to increase their profit margins, even though this was at the cost of losing future market shares. The authors explore several possible reasons why large and small levered firms might behave so differently upon deregulation. Efficiency and excess capacity considerations do not seem to be driving their results. Instead, they provide evidence that large firms had greater access to capital markets than small firms upon deregulation. This allowed large firms to raise capital to expand. At the same time, small producers had a higher probability of going bankrupt than large firms, which explains why small companies were favoring the short-term by increasing prices, at the expense of future market shares. These findings conform well to two very well-known theories. The theory of Brander and Lewis (1986) explains the behavior of large firms, whereas the theories by Bolton and Scharfstein (1990) and Dasgupta and Titman (1998) best explain the behavior of small firms.
The authors also highlight some negative effects of regulation. Specifically, under regulation firms were encouraged to increase debt in order to benefit from the higher prices set by the regulator. This is because debt is considered as a cost for firms, and regulated prices are set to take into account costs, including the costs of debt. However, higher leverage reduced firms’ ability to compete once deregulation took place. This was especially true for small firms, which had a higher probability of exiting the market. The exit of small firms after deregulation went against the initial purpose of liberalization which was to reduce industry concentration.