Endogenous Product Qualities , Financial Structure , and Firm Value by 1

We examine the interaction between financial and microeconomic decisions in a differentiated duopoly under uncertainty as to the heterogeneity of consumer taste for quality. Financing is by equity and/or debt, with limited liability in case of bankruptcy. Product specification is endogenous. The upper-end of the taste distribution is uncertain, and so is the density which varies as to keep the size of the market constant. We consider a game where firms choose qualities (first stage), financial structure (second stage), and prices (third stage), and then uncertainty is resolved and the state of demand revealed. Once debt is contracted, the manager maximizes equity instead of total value. We find that leverage in the high-quality firm’s financial structure a) increases both prices and qualities, b) reduces product differentiation for most parameter values, and c) reduces the value of the levered high quality firm because it induces an upgrade of the low quality product. Despite the negative profitability of strategic leverage in a differentiated products environment, the high quality firm will carry leverage in its structure, unless it has a means to commit ex-ante to using only equity.