Competitive equilibrium with debt

This paper studies the interaction among financing, entry, and exit decisions of firms in a competitive industry subject to aggregate uncertainty. In contrast to Fries, Miller, and Perraudin (1997), I do not assume that a firm in default leaves the industry immediately. The implications on the optimal leverage ratios and equilibrium credit spreads are discussed. By incorporating the effect of competition, I show that the model results in significantly higher credit spreads than those predicted by traditional single firm models. Dynamic capital structure strategies in a competitive industry are also examined. The model renders a number of empirical predictions regarding leverage ratios and credit spreads of firms in a competitive industry. COPYRIGHT 2007, SCHOOL OF BUSINESS ADMINISTRATION, UNIVERSITY OF WASHINGTON.