Financial Contracting when Rivals mayTurn Nasty

This paper develops a principalagent model of nancial contracting in which optimalcontracts resemble a combination of debt and equity. When defaulting on debt, therm is punished by disruption of external funding. Such contracts however, inviterivals to compete more aggressively to increase the likelihood of default. The rm willrespond to the threat of predation, by choosing a less leveraged capital structure, eventhough this will aggravate incentive problems. In contrast to the literature on debtas a device of strategic commitment, this result supports the common presumptionthat equity can enhance the rm's competitiveness in the product market...