Corporate Finance

I explore the strategic role of leverage in the interaction between non-financial industries. Several capital structure puzzles remain some of the major unresolved puzzles of corporate finance. The insight provided by the dominant trade-off theory does not fit the empirical evidence about capital structure. For example, contrary to the theory predictions, leverage ratios are found to be too low and debt-to-equity ratios of similar firms remain quite different. To resolve this puzzle, I employ a network model of corporate capital structure decisions in which every industry (representing a node in the network) makes their capital structure decisions dependent on their trading links (representing the edges of the network) with other industries. I first develop a simple theoretical setup that illustrates the joint behavior of optimal capital structure depending on the intensity in input-output links and given firms’ characteristics. Based on these results, I show in the empirical part of the paper that the position of an industry in the network affects its capital structure policy. The more suppliers or customers an industry has or the more connected to other industries they are, the higher its leverage becomes. My second empirical finding is a positive dependence between partner industries’ leverages. Using a spatial-autoregressive model I show that industries with highly levered partners have a higher leverage themselves. This network effect supports the hypothesis that leverage is used as an instrument to improve a firm’s bargaining position.