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...(1958), Telser (1966), and later Benoit (1984), is used to explain evidence that young firms are more vulnerable to bankruptcy than older firms. For example, over 40% of U.S. firms that went bankrupt in 1997 were less than five years old, while over 66% were less than 10 years old (Dun and Bradstreet, 1998). The deep pocket argument states that since the incumbent has greater financial resources (a "deeper pocket") than the entrant, the incumbent is able to exhaust the entrant financially through engaging in predatory pricing, thereby forcing the entrant to leave the market. Predatory pricing refers to the practice of introducing a lower priced, higher quality, or more innovative product in direct competition with a rival after it enters the market.
However, it is not immediately clear why the incumbent has greater financial resources than the entrant. Telser (1966) and Benoit (1984) simply assume the entrant is financially vulnerable and unable to sustain a price war. A number of authors provide explanations as to why the entrant is more vulnerable. Fudenberg and Tirole (1986) argue that since the entrant does not have a history of cashflow generation, the entrant finds it difficult to find equity investors. Therefore, the entrant must borrow to finance its operations, and must satisfy interest payments requirements. Conversely, the incumbent has a record of cashflow generation and is able to acquire equity investment resulting in lower interest payment requirements. The incumbent is, therefore, able to engage in a price war, as it does not have as large an interest obligation to satisfy.
Williamson (1974) argues that an incumbent has lower financing costs due to its lower risk. The lower risk is due to its existing history of cashflows. Since the entrant is a riskier investment, it must pay a higher interest rate. Therefore, even if both firms have the same financial structure, the incumbent is able to lower prices more aggressively due to the lower interest requirement it faces.
Poitevin (1989) formalizes the deep pocket argument using a game in which the riskiness of the entrant's debt is revealed through a separating equilibrium. Debt acts as a signal of quality to investors, allowing the entrant to receive the same interest rate as the incumbent. However, the higher level of debt and the associated cashflow requirements leave the entrant vulnerable to predation on the part of the incumbent. Hence, the incumbent's reputation permits a flexible financial structure, while the entrant's lack of reputation forces it to use its financial structure as a signal, causing predation. Fulghieri and Nagarajan (1996) also consider the strategic implications of financial structure on "deep pocket" games. However, they develop their model in the context of Benoit (1984), with the same unsatisfying assumption that the incumbent is financially stronger.
The model developed in this study extends Poitevin (1989) to demonstrate that convertible debt can be used advantageously in the context of deep pocket predatory games. Through strategically choosing convertible debt with a specific conversion ratio, an entrant may be able to avoid predation while revealing its quality type through a separating equilibrium. The key difference between the model developed in this study and Poitevin (1989) is that this model allows the firm to issue convertible debt, while the model in Poitevin (1989) does not.
Finance literature provides a number of theoretical rationales to explain why firms issue convertible debt. Kim (1990) argues that the conversion ratio provides a signal to the market of management's expectations of future performance. Jensen and Meckling (1976), Mikkelson (1978), and Green (1984) argue that convertible debt can be used to protect bondholders against the opportunistic behavior of shareholders. Brennan and Schwartz (1988) argue that convertible debt's hybrid nature makes it easier for creditors and debtors to negotiate the value of the debt when there is disagreement about the riskiness of the company. Constantinides and Grundy (1989) discuss the use of convertible debt to overcome problems associated with asymmetric information.
This study is in the spirit of the delayed equity argument first proposed by Brigham (1966) and Hoffmeister (1977). Janjigian (1987) provides empirical support for this argument, and Stein's (1992) backdoor equity model is a recent variant of this explanation. Stein argues that when adverse selection causes equity issues to be untenable and there is a high cost associated with financial distress, managers have an incentive to issue convertible debt. In Stein's model, a medium quality firm will not issue equity, to avoid issuing underpriced equity. At the same time, the medium quality firm will not issue straight debt, to avoid financial distress costs. Instead, the medium quality firm will issue convertible debt to avoid equity issue until quality is determined. Once quality is determined, the medium firm will force conversion through threatening to call. Davidson, Glascock and Schwarz (1995) provide empirical support of Stein (1992) and Kim (1990). Lewis, Rogalski and Seward (1999) find that the reaction to new convertible debt issues depends on whether investors believe that risk shifting or backdoor equity motivates the choice of convertible debt.
The basic argument of this study is as follows. Following Fudenberg and Tirole (1986), Williamson (1974), and Poitevin (1989), the fundamental difference between the incumbent and the entrant is that the market knows the incumbent's quality, while the entrant's quality is unknown. Therefore, the entrant must use debt to overcome informational asymmetries in financial markets. In particular, the firm has information on its cost type not known to the market. Debt issued by the entrant causes predation on the part of the incumbent monopolist, as the incumbent is willing to sacrifice short term cashflows to receive the reward of the entrant's bankruptcy. Using convertible debt with a conversion ratio by which creditors have an incentive to convert only if the entrant is a low cost...
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