Capital Structure and Imperfect Competition in Product Markets (Revision of 24-84; Revised: 11-87)

A linear duopoly model is used to consider investment and financing decisions. Bankruptcy is assumed to cause a delay in investment which is not costly in itself. However, the imperfect competition in the product market means this delay puts the bankrupt firm at a strategic disadvantage which forces it to either reduce its size or, in most cases, to liquidate. This is costly because the firm loses the profits it would otherwise have obtained. As a result firms use only a limited amount of debt despite the corporate tax advantage it enjoys.