Capital Structure and Product Markets Interactions Evidence From Business Cycles

Journal of Financial Economics 68 (2003) 353–378
Capital structure and product markets

interactions: evidence from business cycles$
Murillo Campello
Department of Finance, University of Illinois at Urbana-Champaign, 340 Wohlers Hall,
1206 South Sixth Street, IL 61820, USA
Received 18 December 2000; received in revised form 28 February 2002
Abstract
This paper provides firm- and industry-level evidence of the effects of capital structure on
product market outcomes for a large cross-section of industries over a number of years. The
analysis uses shocks to aggregate demand as surrogates for exogenous changes in the product
market environment. I find that debt financing has a negative impact on firm (relative-to-
industry) sales growth in industries in which rivals are relatively unlevered during recessions,
but not during booms. In contrast, no such effects are observed for firms competing in high-
debt industries. At the industry level, markups are more countercyclical when industry debt is
high. The cyclical dynamics I find for firm sales growth and for industry markups are
consistent with Chevalier and Scharfstein’s (American Economic Review (1996)) prediction
that firms which rely heavily on external financing are more likely to cut their investment
in market share building in response to negative shocks to demand and that the competitive
outcomes resulting from such actions depend on the financial structures of their industry
rivals.
r 2003 Elsevier Science B.V. All rights reserved.
JEL classification: G32; D43; E32
$
This paper is a revised version of Chapter I of my doctoral dissertation at the University of Illinois. I
thank the members of my dissertation committee: Charlie Calomiris, Charlie Kahn, George Pennacchi,
and Mike Weisbach. I am indebted to Charlie Hadlock, Bill Schwert (the editor), and two anonymous
referees for their valuable suggestions. Comments from Naveen Khanna, Peter MacKay, Vojislav
Maksimovic (WFA discussant), Gordon Phillips, and Allen Poteshman were also very helpful. I also
benefited from comments of seminar participants at Arizona State University, Case Western Reserve
University, College of William & Mary, Federal Reserve Bank of Cleveland, Michigan State University,
Penn State University, Purdue University, SUNY at Stony Brook, Western Finance Association 2000
meetings, University of Illinois at Urbana-Champaign, and University of Utah. All remaining errors are
mine.
E-mail address: m-campe@uiuc.edu (M. Campello).
0304-405X/03/$ - see front matter r 2003 Elsevier Science B.V. All rights reserved.
doi:10.1016/S0304-405X(03)00070-9
354 M. Campello / Journal of Financial Economics 68 (2003) 353–378
Keywords: Product markets; Capital structure; Business cycles; Industry rivalry; Markups
1. Introduction
Recent theoretical work on capital structure has emphasized not only the
contracting problems among agents within the firm (e.g., managers and investors),
but also the implications of financing decisions for agents outside the firm (e.g.,
competitors and consumers). This literature stresses that a firm’s mode of financing
influences its conduct in the product market as well as the conduct of other market
participants, thereby influencing competitive outcomes.1 Although these theories
have received much attention, only a few of their implications have been empirically
examined. Directly testing those ideas is a challenging task since it is difficult to
establish whether or not the competitive outcomes associated with a firm’s financing
decisions were already anticipated by the firm’s managers. Another concern with the
interpretation of the empirical relation between capital structure and product market
behavior is the possibility that both a firm’s financial structure and its competitive
performance may be jointly influenced by unobserved (or unmodeled) factors arising
from the market environment. A study of competitive performance following capital
structure changes, for instance, may assign a spurious causality to capital structure if
both performance and recapitalizations are influenced by underlying trends in
industry concentration, excess capacity, and growth (see Kovenock and Phillips,
1997; and Zingales, 1998).
One way to mitigate concerns about the endogenous nature of the relation
between capital structure and competitive performance is to look at performance
following events affecting product market participants’ incentives (or ability) to
compete under existing financing arrangements. This paper uses such an approach to
establish a link between firm financing and product market outcomes. Assuming that
the exact timing, magnitude, and consequences of macroeconomic shocks are not
fully anticipated by product market participants and their financiers, I examine the
sensitivity of markups and sales growth to financial leverage following shocks to
aggregate demand.2 My main focus, however, is on the differences in these
1
A partial list of seminal theoretical papers includes Benoit (1984), Titman (1984), Maksimovic (1986,
1988), Brander and Lewis (1986), Bolton and Scharfstein (1990), and Maksimovic and Titman (1991).
More recent papers are Williams (1995), Chevalier and Scharfstein (1996), Dasgupta and Titman (1998),
and Maurer (1999).
2
In some of my tests, I allow for the possibility that firms could endogenize macroeconomic effects in
their financing decisions. Notice, however, that we do not know whether (and how) firms would account
for those effects in their capital structure. The scant literature on this issue supports that even if
macroeconomic expectations could be incorporated in financing decisions one would still observe the ‘‘side
effects’’ of debt. That literature suggests, for example, that optimal financial structures are unfeasible
owing to practical issues such as tax-induced (and other institutional) biases that prevent firms from using
their capital structure as an aggregate risk-sharing mechanism (see, e.g., Gertler and Hubbard, 1993) and
lack of coordination among agents (Lamont, 1995).
M. Campello / Journal of Financial Economics 68 (2003) 353–378 355
sensitivities across industries in which rivals are more debt-financed and industries
in which rivals are less debt-financed. Such intertemporal and cross-sectional
contrasts help sidestep the problems that usually affect the interpretation of the
empirical relation between capital structure and competitive performance. In
particular, after conditioning on the phase of the business cycle and on competitors’
leverage, my tests show that firm debt leads to sales underperformance in some
industries in certain states of demand realization, whereas under other sets of
circumstances these debt-led losses are either nonexistent or reversed. While such
findings are consistent with extant theories on the effects of capital structure on
competitive performance, the contrasts I use make it difficult to identify alternative
stories (or biases) capable of explaining how debt financing could lead to poor
performance in some specific industries and periods precisely along the lines of the
results I report.
I present two sets of results characterizing the dynamics of the interactions
between capital structure and product market outcomes. First, I use industry-level
data to conduct a direct test of Chevalier and Scharfstein’s (1996) theory of markup
cyclicality. Consistent with their model, I find that markups are more countercyclical
in industries in which firms use more external financing. My estimates suggest that
the markup of a hypothetical ‘‘all-debt’’ industry increases by approximately 42%
more than that of a ‘‘zero-debt’’ industry in response to a 1% decline in gross
domestic product (GDP). My conclusions about debt-led markup countercyclicality
are robust to the inclusion of controls for the level of industry capacity utilization,
market concentration, and product demand cyclicality, among other estimation
considerations.
I then use a panel data set containing quarterly information from firms in 71
industries covering over two decades to study the impact of debt financing on sales
performance at the firm level. My empirical strategy focuses on the differences in
responses of firm sales–leverage sensitivity to macroeconomic shocks across low–debt
and high–debt industries. The results I obtain show that reliance on debt financing
can significantly depress a firm’s (relative-to-industry) sales growth in industries in
which rivals are less leveraged as economic conditions worsen. Comparing the
performance of two firms in a low-debt industry, one firm with a debt-to-asset ratio
10% above the industry average and the other with a debt-to-asset ratio 10% below
that average, I find that the industry-adjusted quarterly sales growth of the more
indebted firm is 1.3% lower than that of its unlevered rival following a 1% decline in
GDP. In contrast, no such effects are observed in industries in which rivals are
relatively more indebted just prior to a similar aggregate shock. These results are
robust to changes in the estimation methodology, to changes in the proxies for
macroeconomic activity, to the inclusion of further macroeconomic conditioning
variables, and also hold across different subperiods of my sample. My conclusions
are also robust to concerns that the results I observe could be driven by the potential
endogeneity between the financing decisions of firms in a particular industry and that
industry’s product demand cyclicality.
I interpret my findings on cross-industry differences in cyclical movements in
markups and in sales-debt sensitivities as consistent with the theory of Chevalier and
Scharfstein (1996). Specifically, my findings agree with the prediction that firms
which rely more heavily on external financing are more likely to reduce their
investment in market share building during downturns and that the competitive
outcomes resulting from such actions are jointly determined by the firm’s and by its
rivals’ capital structures. My firm-level results, however, cannot dismiss a state-
contingent form of Telser’s (1966) ‘‘long purse’’ argument as they suggest that,
conditional on a low demand realization, indebted firms lose more (less) market
share when rivals are relatively unlevered (leveraged).
This study adds to the evidence on interactions between financial structure
and product markets presented in the pioneering work of Chevalier (1995a, b),
Phillips (1995), and Kovenock and Phillips (1997). The paper’s empirical strategy
is most similar to that of Chevalier and Scharfstein (1996), Zingales (1998),
and Khanna and Tice (2000), who look at these interactions during periods when
the competitive environment is affected by exogenous events (e.g., oil shocks,
market deregulation, and entry). While those studies report time- and industry-
specific results, this paper shows that the argument that a firm’s financial
structure influences its competitive performance is considerably more pervasive
and economically significant than previously thought. To my knowledge, this
is the first study to present evidence of a link between capital structure, product
markets, and business cycles, allowing for both firm-level and macroeconomic
inferences.3
The rest of the paper is organized as follows. Section 2 provides an overview of
some of the main arguments relating capital structure and product markets, and it
discusses testable hypotheses. In Section 3, I examine whether industry-wide use of
debt financing influences the behavior of markups over the business cycle. In Section
4, I use firm-level data to examine the relation between firm capital structure and
product market performance via a testing strategy that emphasizes cross-sectional
differences in changes in the sensitivity of sales performance to debt following
macroeconomic shocks. Section 5 concludes the paper.
2. Financial structure and product markets: some theories and hypotheses
The goal of this paper is to empirically examine the argument that capital
structure influences a firm’s (as well as its rivals’) incentives to compete in the
product market, thereby influencing competitive outcomes. Unfortunately, few of
the theoretical studies proposing this argument make clear predictions about how
their results would manifest in the data. Moreover, only some of those predictions
can be simultaneously tested under a single empirical framework, making it difficult
to dismiss one argument in favor of another. In the subsequent analysis, I study
whether the ideas presented in this brief review section are economically significant
3
Subsequent work by Campello and Fluck (2003) provides detailed evidence of these linkages using
firm-level data from manufacturers during the 1990–91 recession.
and pervasive using fairly general empirical models relating debt financing to
product market outcomes.4
One of the prominent theories in the literature about the interactions
between capital structure and product markets is the ‘‘long purse’’ or ‘‘predation’’
argument. The basic story, put forth by Telser (1966) and formalized by Bolton
and Scharfstein (1990), stresses that dependence on outside financing can hinder a
firm’s ability to fight competition, which in turn prompts financially un-
constrained rivals to pursue predatory market strategies. In empirically
examining this argument, researchers often take some measure of debt financing
as a proxy for financial fragility and study whether that measure is associated with
competitive outcomes such as diminished profits and market share losses. The testing
strategy used in this paper goes a step further in that it only takes indebtedness to be
a measure of financial fragility under a set of specific conditions: (1) the firm is
highly-leveraged in relation to its industry rivals, (2) the firm operates in a market
where the use of debt financing is generally low, and (3) there is a negative shock to
demand.
Financial fragility may also hinder competitiveness in models in which firms
use pricing as a means of investing in long-term market share building instead of
as a means of maximizing single-period profits (e.g., Gottfries, 1991; Chevalier
and Scharfstein, 1996). Chevalier and Scharfstein argue that liquidity-
constrained firms are less inclined to invest in market share building when
their liquidation probability is high. In recessions, externally financed firms
will be more inclined to boost price-cost margins at the expense of future
sales.5 Since prices are strategic complements, their rivals will also inflate
prices, but by an extent given by their own finances. As those rivals also raise
their prices, the market share losses of the more constrained firms are reduced. It
follows that the degree of firm markup cyclicality should depend both on the firm’s
own financial constraints as well as on the financial status of rivals in the industry. At
the industry level, markups should be less cyclical if firms use more external
financing.
An alternative line of argument suggests that debt could contribute to firm
competitive performance. According to the ‘‘strategic commitment’’ theory
of Brander and Lewis (1986), a firm’s decision to use debt works as a commitment
to more aggressive behavior in the product market. This threat is credible because
of the option-like payoffs associated with debt under limited liability and induces
the firm’s unlevered rivals to accommodate by reducing their output (also
see Maksimovic, 1986). If ex post this dynamic is found to work in the data,
4
Related theoretical papers not reviewed here include Titman (1984), Rotemberg and Scharfstein
(1990), and Maksimovic and Titman (1991). See Maksimovic (1995) for a detailed review of the theoretical
literature.
5
Firms can do so if switching costs allow them to extract more of their customers’ reservation utility
without necessarily losing their business in the short run. See Dasgupta and Titman (1998) and Campello
and Fluck (2003) for models with a similar flavor.
then one should observe market share gains for the more leveraged firms.
One difficulty in testing this idea, however, is that the availability of such gains
should ex ante lead to a prisoners’ dilemma-like behavior in which rival firms would
use more debt.
Finally, debt financing could be related to performance in a noncausal sense. In
the ‘‘industry equilibrium’’ models of Maksimovic and Zechner (1991) and Williams
(1995), the optimal set of financial contracts for each firm in a industry is jointly
determined with various industry characteristics, such as the number of firms,
riskiness of projects, and technologies. Williams proposes a stable industry
equilibrium supporting the coexistence of profitable firms that are large, make more
fixed-capital investments, and use more debt, with smaller firms that are less
profitable and use low debt. While my experiments are not designed to formally test
this theory, I briefly discuss whether my results could be ascribed to such an
equilibrium-type story.6
3. Industry-level evidence on markup movements over the business cycle
Chevalier and Scharfstein (1996) predict that if most firms in an industry are
externally (internally) financed, then the industry markup will be more counter-
cyclical (procyclical). In this section, I use industry-level data to test this hypothesis.
The results presented here are relevant in their own right—extending the analysis in
Chevalier and Scharfstein (1995, 1996)—but they are also useful for the firm-level
tests conducted in Section 4. Specifically, I explore the cyclical cross-industry
differences in the relationship between competitive outcomes and financial structure
that are identified in this section to address the potential for estimation biases in my
firm-level tests.
3.1. Data and methodology
Detailed industry-level data are typically compiled by governmental agencies and

are published at the two-digit standard industry classification (SIC) level. To
perform the tests of this section, I gather data from 20 two-digit SIC classified
manufacturing industries. These industries are listed in Table 1 below. The
most important data series I need for my experiments are industry markup and
leverage.
There is no consensus in the literature about the best measure of industry markup.
Because the proxy proposed by Bils (1987) is less likely to overstate the degree of
markup countercyclicality (see Rotemberg and Woodford, 1991), and thus less likely
to allow for unwarranted conclusions about the impact of capital structure on
markups over the cycle, I choose that proxy for my tests. In contrast to other
6
See MacKay and Phillips (2002) for a detailed empirical examination of industry-equilibrium theories.
Table 1
Industry summary statistics. Industries are defined at the two-digit SIC code level and the sample period is 1984:IV–1996:IV. Leverage is computed quarterly
as the asset-weighted average debt-to-asset ratio using firm-level data from COMPUSTAT. Capacity utilization is available from the Federal Reserve’s
Statistical Release G.17. Four-firm concentration ratios are taken from Table 2 in Rotemberg and Saloner (1986). The durable versus nondurable dichotomy
is from Sharpe (1994).
SIC Industry description Leverage ratio Capacity utilization (%) Four-firm (%) Sharpe’s (1994) dichotomy
concentration ratio
Mean (Std. dev.) Mean (Std. dev.)
20 Foods 0.26 0.03 83.38 0.90 34.50 Nondurable

21 Tobacco 0.27 0.03 N/A N/A 73.60 Nondurable
22 Textile mills 0.37 0.04 87.21 3.16 34.10 Nondurable
23 Apparel 0.22 0.05 81.43 2.38 19.70 Nondurable
24 Lumber 0.31 0.03 85.59 4.28 17.60 Durable
25 Furniture/fixtures 0.23 0.05 80.88 3.14 21.60 Durable
26 Paper 0.28 0.03 89.46 2.02 31.20 Nondurable
27 Printing/publishing 0.24 0.02 84.21 3.76 18.90 Nondurable
28 Chemicals 0.18 0.01 80.43 2.31 49.90 Nondurable
29 Petroleum 0.15 0.01 88.29 3.49 32.90 Nondurable
30 Rubber and plastics 0.25 0.05 86.10 2.94 69.10 Durable
31 Leather 0.20 0.07 78.79 4.92 24.50 Nondurable
32 Stone, clay, and gas 0.35 0.06 78.31 3.15 37.40 Nondurable
33 Primary metals 0.22 0.02 83.67 6.49 42.90 Durable
34 Fabricated metals 0.27 0.02 78.81 3.35 29.10 Durable
35 Industrial machinery 0.16 0.02 78.93 5.38 36.30 Durable
36 Electrical machinery 0.15 0.02 81.32 3.63 45.00 Durable
37 Transport. Equipment 0.26 0.09 76.34 3.72 50.10 Durable
M. Campello / Journal of Financial Economics 68 (2003) 353–378
38 Instruments 0.19 0.03 N/A N/A 47.80 Nondurable

39 Misc. manufactures 0.20 0.06 75.59 3.81 N/A Durable
N/A: Not available.

359
markup measures, Bils’s proxy allows for the marginal cost of one hour of labor to
change with the level of hours worked in the industry.7 This is relevant for tests using
data from manufacturers since hours worked vary over the business cycle and firms
in this sector are required by law to pay a premium for overtime hours. Similarly to
other markup proxies, however, Bils’s measure might do a relatively poor job in
capturing productivity shifts over the cycle.8
The measure of industry markup I operationalize—a slightly simplified version of
Bils (1987)—is computed in terms of log deviations from trend:

Markupt ¼ ln Pt =MCt ¼ lnðPt Þ lnðwt Þ

ln 1 þ rV 0 ðHt Þ ln Ht jt Nt =Yt trend constant; ð1Þ
where P is price, w is hourly average wages, r is the legal overtime premium (set to
50% by the Fair Labor Standards Act of 1938), H is weekly average hours, V(H) is
overtime hours, j is the number of weeks in the period, N is the number of
production workers, and Y is gross output. The change in overtime hours with
respect to a unit change in average hours, V (H), equals one when the weekly average
hours of work in the industry exceeds 40 hours and equals zero otherwise.
To construct the markup series, I gather industry price data, P, from the Bureau of
Labor Statistics’ (BLS) Producer Price Indexes. N, H, and w are taken from the
BLS’s National Employment, Hours and Earnings. These publicly available series are
compiled on a monthly basis, and I use their quarterly averages. Y is collected from
the Bureau of Economic Analysis and is available on an annual basis only. To obtain
Y at a quarterly frequency, I interpolate each one of the industry series with
quarterly gross national product (GNP). I can only match all of these series
beginning in the fourth quarter of 1984.9
To measure industry leverage, on a quarterly basis, I compute the asset-weighted
average long-term debt-to-asset ratio of firms with identical two-digit SIC codes in
COMPUSTAT’s Primary, Supplementary, Tertiary, Full Coverage, and Research
tapes (all at book values). The sample period for the tests in this section is from
1984:IV through 1996:IV. Summary statistics for various industry characteristics are
reported in Table 1.
7
The production technology is of the form Y=Haf(factors other than H), where Y is output and H is
hours worked. If the cost of labor is a function of hours worked, W(H), the cost of marginally increasing
hours, holding all other inputs, including employment, N, at their cost-minimizing values (indicated by *),
is then:

MC ¼ dCosts=dH dH=dY Y ; H ; etc: ¼ 1=a H =Y dCosts=dH

¼ W H þ W 0 H H 1=a H N =Y :
Marginal costs include straight-time wages, movements along the marginal wage schedule, and a
productivity term.
8
As noted by a referee, this is a potentially important limitation. Some of the results below should thus
be interpreted with caution.
9
The exceptions are SICs 36 and 38, for which pre-1987 data are discarded because of the well-known
difficulties in reconciling information from the 1972 and the 1987 SIC code structure.
To test whether markups are more countercyclical in industries in which rivals are
more externally financed, I regress industry markup movements on a measure of
aggregate activity, industry leverage, and a term interacting activity and leverage.
Macroeconomic movements are proxied by changes in the negative of log real GDP.
Increases in this measure represent economic slowdowns, the consequences of which
I want to emphasize in this paper. To minimize simultaneity between markup and
leverage, the latter variable enters the specification in lag form. The empirical model
can be written as

Markupi;t ¼ Z þ a DLogðGDPÞt þ bLeveragei;t1

þ l Leveragei;t1 DLogðGDPÞt þ ei;t : ð2Þ
In all estimations of this model, I use Huber–White heteroskedasticity-consistent
errors, allowing for within-period error clustering (see Rogers, 1993).
3.2. Results
The first estimation reported in Table 2 examines whether markups are

countercyclical, as shown in previous studies in the macroeconomics literature. I
simply regress markup movements on the proxy for aggregate activity and a constant
via ordinary least squares (OLS). The results point to markup countercyclicality in
my data. The estimates suggest that a 1% decline in GDP brings about a 10%
increase in (relative-to-trend) industry price-cost margins. This result is statistically
significant at the 1% level.
In the next set of regressions, I include industry-level variables. Since I cannot
reject the presence of industry-fixed effects via standard tests, I estimate Eq. (2) with
data in first differences (see Hsiao, 1986). The OLS-fixed effects (OLS-FE) estimates
displayed in the second row of Table 2 are the most important results of this section.
The significantly positive coefficient for the interaction term indicates that higher
industry-wide indebtedness leads markups to increase faster during downturns.
Consistent with Chevalier and Scharfstein (1996), these estimates suggest that
negative shocks to demand prompt firms to raise price-cost margins more (or cut
them less) in industries with more externally financed competitors.
To gauge the macroeconomic implications of these results, note that estimates in
the second row of the table imply that the markup of a hypothetical ‘‘all-debt’’
industry would increase by nearly 42% more than that of a ‘‘zero-debt’’ industry in
response to a 1% decline in GDP. This finding points to feedback effects going from
the corporate sector to the overall economy, with potential policy implications. For
instance, this evidence suggests that past firm financing decisions may become a
source of inflationary pressures during recessions.
3.3. Interpretation and robustness
A potential problem with the interpretation of the results reported in the second
row of Table 2 is that the business cycle measure I use may not distinguish between
changes in markups that are caused by demand shocks from those that are caused by
362
Table 2
Industry debt and markup movements over the business cycle. The dependent variable is based on Bils’s (1987) measure of industry markup movement [see
Eq. (1)]. Industries are defined at the two-digit SIC code level and the sample period is 1984:IV–1996:IV. Estimations include a constant term (coefficients
omitted). The measure of cyclicality is the negative of the log real GDP. Leverage is computed quarterly for each industry as the asset-weighted average debt-
to-asset ratio using firm-level book data. Capacity utilization is the industry quarterly production as a percentage of normal production. Cost shocks are
proxied by the change in fuel and energy price index to industry commodity PPI. The durables-nondurables dichotomy is from Sharpe (1994). The ‘‘high’’
four-firm concentration dummy is based on data from Rotemberg and Saloner (1986). Fixed effects (FE) estimations eliminate industry effects by differencing
the data. Two-stage least squares (2SLS) are used to control for biases caused by differencing if leverage is only weakly exogenous. The set of instruments
includes two lags of leverage (in levels). All estimations use Huber-White heteroskedasticity-consistent t-statistics allowing for within-period error clustering.
Estimator Dlog(GDP)t Leveragei,t1 Levi,t1 [Dlog(GDP)t] DEnergy Capacity Durables Concentration Adj-R2 Obs.
pricet utili,t1 dummy dummy
1. OLS 10.0764 0.046 924

(5.836)
2. OLS-FE 6.1456 1.0453 146.8777 0.035 924
(3.542) (2.856) (2.712)
3. OLS-FE a 6.9705 1.0727 137.7774 0.9345 0.051 832
(4.047) (2.999) (2.587) (3.259)
4. OLS-FE b 7.0551 1.0447 128.4153 0.0047 0.055 842
(4.103) (4.638) (3.248) (0.709)
5. OLS-FE 6.1507 1.0479 146.6471 0.0016 0.031 924
(3.905) (3.266) (2.754) (1.120)
6. OLS-FE 6.0988 1.1362 151.0229 0.0015 0.033 924
(3.717) (3.441) (2.764) (1.070)
7. 2SLS-FE 9.0880 0.9587 237.9982 0.036 859
(4.829) (1.433) (2.481)
a
Excludes SICs 35 and 37.
b
Excludes SICs 21 and 38.
cost shocks. For instance, if following a supply side shock such as an increase in
energy prices, GDP falls and unemployment increases, then markups could appear
to be countercyclical even when changes in aggregate demand are of second order.
Following Rotemberg and Woodford (1996) and Ghosal (2000), I control for cost
shifts in the estimation of Eq. (2) by adding a proxy for changes in energy prices.
This variable is measured as the change in the ratio of the fuel price index to the
producer price index (PPI) of industrial commodities. As noted by Ghosal, changes
in energy prices will affect not only costs but also demand in some industries. Using
that author’s approach, I therefore exclude industries that are likely to fall in this
category (SICs 35 and 37) from the estimation. The results for the new specification,
shown in the third row of Table 2, support my previous conclusions.
Although I design my tests to mitigate concerns with various types of estimation
biases, admittedly, I am unable to obtain bias-free results. In turn, I examine some of
the most compelling cases for biases potentially affecting my conclusions about debt-
led markup countercyclicality.
One could argue, for instance, that the level of utilized capacity may influence
markup movements and also help explain countercyclicality through leverage if debt
is used to finance expansions. In response, in an alternative specification to Eq. (2) I
add lagged industry capacity utilization as a control. The data on industry capacity
utilization I use are quarterly averages of monthly series taken from the Federal
Reserve’s Statistical Release G.17 (data for SICs 21 and 38 are not available).
Including this variable is particularly useful in that it may also capture other
underlying trends in the industries sampled. Results displayed in the fourth row of
Table 2 show that my conclusions are unaffected by the inclusion of that extra
control.
Alternatively, suppose that sales are more sensitive to the level of aggregate
activity in some industries than in others and that firms in cycle-sensitive industries
choose (ex ante) to carry low debt. In this case, too, markups could fall more in less
leveraged industries during recessions. But if this story drives my results, I would
expect the evidence of debt-led markup countercyclicality to disappear—or, at least,
the magnitude of the coefficients to be affected—once I explicitly account for cycle-
sensitivity in my empirical specification. Following the approach used by Chevalier
and Scharfstein (1995) in addressing a similar concern, I add an indicator variable
for cycle-sensitive industries to Eq. (2). This dummy is based on the dichotomy
proposed by Sharpe (1994), which groups industries according to the covariance
between their sales and the GNP. The set of high covariance industries includes all of
the durable goods industries (except SICs 32 and 38) plus SIC 30. I refer to these
industries as ‘‘durables.’’ In the fifth row of Table 2, I report the results obtained
after including the durables dummy. The size and significance of the debt-cycle
coefficients suggest that my results cannot be explained away by that alternative
story.
Another explanation for why price-cost margins may rise in recessions is that firms
in noncompetitive markets may be more likely to collude when gains from deviation
strategies are not promising (see Rotemberg and Saloner, 1986; and Rotemberg and
Woodford, 1991). Chevalier and Scharfstein’s (1996) theory of financial structure
determining markup movements over the cycle questions this view. But if
concentration and debt are positively correlated, then my results could be reflecting
that collusion story, and I would be too aggressive in rejecting the null of capital
structure irrelevance. To address this concern, I modify Eq. (2) by including a
dummy variable based on the same four-firm concentration ratios used by
Rotemberg and Saloner. I assign to the ‘‘high concentration’’ dummy those
industries with ratios above the median ratio in Table 2 of their paper. The estimates
in the sixth row of Table 2 below suggest that capital structure explains industry
markup cyclicality despite differences in market concentration.
Finally, because data differencing can bias the OLS estimator if regressors are only
weakly exogenous, I perform a two-stage stage least squares (2SLS) estimation of
Eq. (2) in which leverage is instrumented by two lags of itself, with the interaction
term being modified accordingly.10 The 2SLS estimates in the seventh row of Table 2
strongly support my previous conclusions about debt-induced markup counter-
cyclicality. In unreported regressions, I use changes in the unemployment rate as the
proxy for cycles, obtaining qualitatively similar results. The same applies when I use
log changes in prices (rather than markups) as the dependent variable in Eq. (2).
These robustness checks make it difficult to dismiss the evidence of a link between
corporate financing and markup cyclicality stemming from debt-induced behavior in
product markets.
4. Firm-level evidence on market share building over the business cycle
The endogeneity of financing decisions at the firm level makes it difficult to

identify a causal relationship in which the direction goes from capital structure to
competitive performance. Any testing of the theory on product market and capital
structure interactions has to explicitly accommodate the need to address concerns
with endogenous and other estimation biases. Unfortunately, this is not an easy task.
One way to minimize such concerns is to look at competitive performance following
exogenous events altering both the product market environment and rival firms’
incentives (or ability) to compete under an existing set of financing arrangements (see
Zingales, 1998). The firm-level tests of this section use such an approach.
In identifying events suitable for a my testing strategy, I consider a number of
issues. First, there must be an exogenous, real-side shock to the competitive
environment. Second, the shock must allow for unanticipated effects of financial
structure. In other words, the nature of the shock should make it difficult for firms
and their financiers to fully endogenize all of its consequences in their financing
arrangements (contracts). Third, the event should not be industry-specific, but rather
affect a large cross-section of industries at the same time. This last requirement
generates useful cross-sectional contrasts for the relation between a firm’s
performance and its rivals’ finances.
10
Following Arellano (1989), I instrument the differenced regressors with their lagged levels.
Estimations with longer and more complex lag structures yield qualitatively similar results.
I find that periods surrounding shocks to aggregate demand provide the

conditions needed for my proposed tests. In particular, consider the post-war
recession episodes in the United States. These have been typically accompanied by
contractionary measures by the monetary authority as well as tougher credit terms
for borrowers.11 Since debt is likely to bind firm behavior in periods when income
from operations is unusually low, and because it is difficult to renegotiate debt
contracts when credit is tight, those concurrent macroeconomic movements should
provide for crisp results on the relation between capital structure and product
markets. Specifically, concerns with simultaneity problems affecting the interpreta-
tion of the empirical relation between firm performance and capital structure will be
lessened around these exogenous shocks to demand and credit: The shocks will affect
all firms in a market, but according to the theory, those firms should respond
differently to the shocks depending on their own financing and on the financing of
their rivals. I examine these cross-sectional differences and their intertemporal
evolution in the tests that follow.
4.1. Data
I set out to put together firm-, industry-, and macro-level data for a period
long enough to capture a number of shocks to aggregate activity. Issues concerning
data availability and consistency lead me to restrict the analysis to the 1976:
I–1996:IV period. The firm-level data (all inflation-deflated) are obtained from
the COMPUSTAT tapes. Using the quarterly tapes, I retrieve book data on
total assets; long-term debt; sales; and plant, property, and equipment (PPE). I use
a firm’s primary three-digit SIC code to identify its product market, restricting
the analysis to firms in the 200-399 SIC range (manufacturing). Following
Clarke (1989), I discard firms assigned to SICs that fail to identify economically
meaningful markets.12 Firms with negative equity or with sales growth
exceeding 200% in one quarter are also discarded. Finally, because my
estimations use industry-adjusted data, only industry-quarters with a minimum
of ten firms are retained in the sample. After these screening criteria are imposed, I
obtain a panel of 128,133 firm-quarters distributed across 71 three-digit SIC
industries. The industry and macro-level data come from various sources and are
described below.
4.2. Measuring firm performance
In examining the interactions between product markets and capital structure,

empirical research has often linked price-setting behavior with some aspect of debt
11
Evidence on such co-movements in financial and real macroeconomic variables is provided in
Bernanke and Blinder (1992), Christiano, et al. (1996), and Lown and Morgan (2001), among others.
12
Some firms may be too diversified or lack enough counterparts to make up a three-digit industry.
These firms are assigned to three-digit codes ending with zero. Other codes combine ‘‘miscellaneous’’ and
‘‘not elsewhere classified’’ businesses and seem unfit for inclusion in my tests. See Clarke (1989) and Kahle
and Walkling (1997) for more details.
financing (see, e.g., Chevalier, 1995b; Phillips, 1995; Chevalier and Scharfstein,
1996).13 In some settings, pricing decisions should reasonably reflect how a firm’s
financial status affects its competitive behavior. More generally, though, firms can
implement a number of alternative policies that significantly affect product market
outcomes but that may not be reflected in how they price their products. Examples of
such policies are decisions about fixed investments, research and development
expenditures, and use of promotions. One way to build a practical measure of
performance that incorporates information from the combined effects of pricing and
other market strategies is to look at changes in the firm’s share of its industry sales.
In this section, I use a firm’s relative-to-industry sales growth (which I improperly
refer to as market share growth) to gauge its performance in the product market.
This proxy can be seen as a suitable compromise for the proposed analysis: It can be
consistently measured across many industries and periods, but it is too general to pin
down the particular mechanisms contributing to competitive behavior in each of the
markets sampled.
4.3. Estimation methodology
4.3.1. A two-step procedure

The estimation methodology I use is very similar to that of Kashyap and Stein
(2000) and Campello (2002). The idea is to estimate the effect of macro-level shocks
on micro-level (firm) ‘‘sensitivities’’ via a two-step procedure that combines cross-
sectional and times series regressions. The approach sacrifices estimation efficiency
but reduces the likelihood of Type I inference errors; that is, it reduces the odds of
concluding that capital structure matters when it does not.14
The initial step of the two-stage estimation consists of a purely cross-sectional
regression that is meant to produce a time-specific estimate of the sensitivity of
product market performance to financial structure. At each quarter, t, I regress the
log change of firm i’s sales on four lags of itself, four lags of the log change in PPE,
the lagged log of total assets, and the lagged leverage ratio:
X
4
DLogðSalesÞi;t ¼ Zþ ak DLogðSalesÞi;tk
k¼1
X
4
þ bk DLogðPPE Þi;tk þlLogðAssetsÞi;t1
k¼1
þ dLeveragei;t1 þ ei;t : ð3Þ
13
Exceptions are Kovenock and Phillips (1997) and Zingales (1998), who study product market
outcomes such as plant closings and market exit.
14
The alternative one-step regression—with Eq. (4) nested in Eq. (3)—would impose a more constrained
(efficient) parametrization. However, results from tests of coefficient stability show that the data strongly
reject parameter constancy across different time periods and industry groups, weakening the case for
efficiency. An added advantage of the approach used is that it relaxes the restriction of homogeneous error
structure across time.
Lags of sales growth are included to control for firm-specific characteristics that
contribute to performance over time. Changes in PPE and total assets are also
included as controls on grounds that the leverage coefficient may be biased if the
model fails to control for investment spending (which might have been financed with
debt) or for the portion of leverage that is explained by a higher borrowing capacity.
My focus is on the estimate of the sensitivity of sales growth to leverage (d). To help
reduce the potential for reverse causality between sales performance and debt, I
compute leverage as the ratio of the book value of long-term debt to total assets.
This measure best suits my tests for at least two reasons. First, in contrast to market
values, book values of debt are less sensitive to capital markets’ assessments about
future cash flows. Second, while leverage changes are likely to reflect changes in
expectations about future product market outcomes, long-term leverage levels are
more likely to reflect the cumulative effect of past decisions.
Before estimating Eq. (3), I adjust all observations of the dependent variable for
their industry-specific sales-weighted means, so that this variable measures the firm’s
sales growth relative to that of its competitors.15 The right-hand side variables are
also industry-adjusted, and thus the average rival’s leverage is the metric used to
measure a firm’s indebtedness. These adjustments facilitate the interpretation of the
regression results and minimize the potential for biases induced by unobserved
industry effects. After each run of Eq. (3), the estimated leverage coefficient is
collected and ‘‘stacked’’ in a time series vector, dt.
In the second stage, I regress the resulting time series of first-stage coefficients—
that is, the dt vector—on four lags of a measure of economic activity that proxies for
the worsening of macroeconomic conditions (DActivity), plus a constant and a time
trend:
X
4
dt ¼ Z þ fk DActivitytk þ gTrendt þ ut ð4Þ
k¼1
I use two alternative proxies for negative shocks to activity in all estimations
performed: (1) the negative of the change in log real GDP, and (2) the change in the
unemployment rate ( 100).16 Because my tests should help distinguish between real
and financial explanations for the observed relation between sales growth and debt, I
also check whether the proxy for economic activity retains significant predictive
power after conditioning on other macroeconomic factors. To do so, I estimate
15
The COMPUSTAT tapes do not contain data on the entire universe of firms. The tapes usually lack
data on very small industry players, and thus the market share figures for the firms in my sample are likely
to be slightly inflated. These data coverage limitations should not systematically bias my conclusions in
any particular direction.
16
To see how this procedure accounts for the error contained in the first step, assume that the true d*t
equals what is estimated from the first-step run (dt) plus some residual (et): d*t =dt+et. One would like to
estimate Eq. (4) as d*t =Z+Xb+ot, where the error term would only reflect the errors associated with the
specification of the model. However, the empirical version of Eq. (4) uses dt (rather than d*t ) on the right-
hand side. Consequently, so long as E[X0 e]=0, Z will absorb the mean of et, while ut will be a mixture of et
and o t. That is, the measurement errors of the first step will increase the total error variance in the second
step, but will not bias the coefficient estimates in b.
alternative versions of Eq. (4) that include additional macro variables: (1) the
Federal Reserve funds rate (Fed funds), (2) the spread between the rates paid on six-
month commercial paper and 180-day T-bills (paper-bill spread), and (3) the
consumer price index (CPI).17 These series are obtained from the Federal Reserve’s
Statistical Release H.15 and from the BLS. In a ‘‘bivariate’’ version of Eq. (4), I add
the change in the Fed funds rate to the right-hand side as a proxy for the stance of
monetary policy. In a ‘‘multivariate’’ version of Eq. (4), I also include the changes in
the paper-bill spread and changes in the CPI.
To gauge the economic relevance and the statistical significance of shocks to
demand on the sensitivity of sales growth to debt, I compute both the sum of the
coefficients for the four lags of the measure of economic activity—that is, the Sfk’s
in Eq. (4)—as well as the p-value of this sum. If feedback effects are not too large,
that sum yields a good first-order approximation of the impact of the right-hand side
variables of interest. I also report p-values for the rejection of the hypothesis that the
four lags of the measure of economic activity do not help forecast the sensitivity of
sales growth to debt. To assess the impact of debt on sales growth over a longer
horizon (four-quarters ahead), I also estimate a version of Eq. (3) in which the
dependent variable is computed as [Log(Sales)t+3Log(Sales)t1]/4. To ensure the
robustness of my results, at each pass, I estimate each of the two versions of Eq. (3)
both via OLS and 2SLS. In all estimations, I use Newey and West’s (1987)
heteroskedasticity- and autocorrelation-consistent standard errors.
4.3.2. Cross-industry comparisons

Although the use of exogenous shocks to the competitive environment such as
recessions help lessen concerns about endogeneity in the performance-capital
structure relation, the estimations are not free from simultaneity biases arising from
unobservable firm characteristics that could influence both a firm’s debt before the
recession begins and its sales performance afterwards. Fortunately, the theories
considered provide for a way of addressing this problem. Those theories propose
that the extent to which a firm’s financing influences its competitive performance
should be a function of the financial status of its competitors, and thus a firm’s
performance-capital structure relation should differ across industries depending on
rivals’ finances. Accordingly, in the tests of this section I compare estimates of firm
sales-debt sensitivities from industries in which rivals are relatively more leveraged
with those from industries in which rivals are less leveraged.18 Focusing on
differences in responses of sales-debt sensitivities to macroeconomic shocks across
17
The paper-bill spread serves as a proxy for the economy-wide perceived risk of default (see, e.g.,
Bernanke, 1990). Korajczyk and Levy (2003) find that this spread has predictive power over firms’
‘‘target’’ leverage.
18
Recall, the results in Section 3 already indicate that rivals’ finances influence product market
dynamics. Those results implied less competition in the price-setting dimension during recessions when the
average industry competitor is more indebted. The interpretation was that an indebted firm facing a
recession is able to increase prices more without loosing customers when its rivals are also leveraged and
are therefore expected to behave in the same way.
sets of firms in different industry debt categories will render irrelevant the concerns
that my two-step estimated coefficients could be biased in the levels.19
Implementing a test that emphasizes those contrasts is a straightforward task with
my two-step procedure. At each quarter, t, I rank the sample industries according to
their leverage ratios and assign firms in the bottom and top quintiles of that industry
ranking to ‘‘low-debt’’ and ‘‘high-debt’’ industries, respectively. Next, also on a
quarterly basis, I estimate Eq. (3) separately for firms competing in low-debt
industries and for firms in high-debt industries as of the previous period (t1),
saving the estimated leverage coefficients from each of these cross-sectional
regressions in individual time series vectors. These series are used as the dependent
variables in separate estimations of Eq. (4), and the results from these estimations
are then compared.
To facilitate comparisons of results across the industry groups, I report not only
the individual estimated responses of sales-debt sensitivities to macro shocks for
firms in the low-debt and in the high-debt groups, but also the differences in these
responses. Standard errors for the ‘‘difference coefficients’’ are estimated via a
seemingly unrelated regression (SUR) system that combines the two industry groups
(p-values reported).
4.4. Results
Fig. 1 provides descriptive evidence of remarkably distinct dynamics for the

relation between a firm’s sales performance and its capital structure conditional on
rivals’ finances and on the state of aggregate demand. The figure shows the cyclical
behavior of the first-step estimated sales-debt sensitivities (dt) of low- and high-debt
industries for the 1977:II–1996:IV period; where I isolate the cyclical from secular
movements in dt using the Hodrick and Prescott (1980) decomposition. Notice that
the sales-debt sensitivity of firms in low-debt industries trails below its trend twice:
During the downturns of the early 1980s, and in a more prolonged period that starts
with the 1990–91 recession. The cyclical behavior of high-debt industries’ dt is
markedly different.
Table 3 presents estimates of the impact of negative shocks to macroeconomic
activity on firm sales-debt sensitivities for both low- and high-debt industries and for
different combinations of first- and second-step specifications. Panel A displays
results from models in which the dependent variable is the series of first-step dt’s
estimated via OLS, while results in Panel B are for dt’s estimated via 2SLS. Across
rows, the top half of each panel features the negative of the change in log real GDP
as the proxy for shocks to activity, while in the bottom half the change in the
unemployment rate is the relevant measure of change in aggregate conditions. Each
panel displays six pairs of estimated responses of the one-quarter ahead dt to shocks
to economic activity [i.e., the Sfk’s in Eq. (4)] along with the associated SUR results
19
This is true unless there exists some reason why those biases should be systematically more
pronounced in certain industries than in others precisely along the lines of the sample partition I use. I
consider one such possibility in detail below.
0.12
0.08
0.04
0.00
δt
-0.04
-0.08
-0.12
7
6
Jun-7
Jun-7
Jun-7
Jun-8
Jun-8
Jun-8
Jun-8
Jun-8
Jun-8
Jun-8
Jun-8
Jun-8
Jun-8
Jun-9
Jun-9
Jun-9
Jun-9
Jun-9
Jun-9
Jun-9
Time
Low-debt industries High-debt industries
Fig. 1. This figure shows the cyclical behavior of the first-step estimated sales-debt sensitivity of firms in
low-debt and those in high-debt industries over the 1977:II–1996:IV period. Quarterly estimates of the
sales-debt sensitivities are obtained from the estimation of Eq. (3) in the text via 2SLS. The estimations are
performed separately over the two industry subsamples with the coefficients returned for leverage (d) saved
into two separate times series. Firm-quarters are assigned to either low- and high-debt industries
conditional on whether their three-digit SIC defined industries were ranked in the bottom or in the top
quintile of the industry-wise leverage debt-to-asset ranking, respectively, as of the quarter preceding the
estimation of Eq. (3). Cyclical and secular movements in dt are isolated using the Hodrick and Prescott
(1980) decomposition (bandwidth of 1600).
for differences in responses across industry groups (i.e., the low-debt Sfk’s minus the
high-debt Sfk’s). To conserve space, I only report the difference coefficients for the
four-quarters ahead dt’s.
Focusing first on the results for the one-quarter dt’s of Panel A, note that for each
of the regression pairs the impact of the macro variable of interest is negative for
firms operating in low-debt industries. These coefficients are statistically significant
at the 2% level in all but one of the estimations. In contrast, for firms in high-debt
industries, none of the coefficients is significantly different from zero, with most of
them returning a positive sign. The differential impact of economic downturns on
sales-debt sensitivities across high- and low-debt industries reported in Table 3 (see
the Low High columns) is negative for all regression pairs. The differences are
statistically significant at the 2.9% level or better in 9 of the 12 cases. Somewhat
stronger results are reported in Panel B, which uses 2SLS-estimated dt’s. These
findings suggest that, following negative shocks to activity, highly leveraged firms
lose market share in industries in which rivals are relatively unleveraged, but that
those losses are reversed in booming periods. In stark contrast, such competitive
dynamics are not observed in high-debt industries.
The exclusion test p-values indicate that changes in the state of the economy are
particularly relevant in predicting the sensitivity of firm sales growth to leverage in
low-debt industries. For multivariate estimations, the business cycle measures have
marginal predictive power at the 4% level or better in all cases. This shows that
Table 3
Sales-debt sensitivities and the business cycle: two-stage estimator. The dependent variable is the sensitivity
of sales growth to leverage [estimated either via ordinary least squares (OLS) or two-stage least squares
(2SLS)] for firms operating in industries categorized as low- versus highly-leveraged. In each estimation,
the dependent variable is regressed on four lags of a measure of aggregate economic activity, a constant,
and a time trend. In the bivariate regressions, the change in the Fed funds rate is added. In the multivariate
regressions the changes in Fed funds rate, the change in the CPI, and the change in the spread between the
rates on commercial paper and the six-month T-bill are included. The sample period is 1976:I–1996:IV.
The sum of the coefficients for the four lags of the economic activity measure is shown along with the p-
value for the sum. Exclusion test rows report the p-values for the rejection of the hypothesis that the four
lags of the economic activity measure do not forecast the sensitivity of sales growth to debt.
Heteroskedasticity- and autocorrelation-consistent errors are computed with a Newey and West (1987)
lag window of size four in the one-quarter ahead regressions. The standard errors for the difference of the
sum of the four lags of the economic activity measure are computed with a seaming unrelated regression
(SUR) system that estimates industry group regressions jointly.
One-quarter d Four-quarters d
Low-debt High-debt Low High Low High
Panel A: Dependent variable is the OLS-estimated sensitivity of sales growth to leverage

1. Economic activity measure is the (negative) change of log real GDP
Univariate Sum of coefficients 4.753 1.637 6.390 15.016
Summation test (p-value) 0.009 0.466 0.015 0.004
Exclusion test (p-value) 0.099 0.588
Bivariate Sum of coefficients 6.345 1.610 7.955 19.084
Multivariate Sum of coefficients 6.300 1.835 8.135 19.546
2. Economic activity measure is the change in the rate of unemployment ( 100)

Panel B: Dependent variable is the 2SLS-estimated sensitivity of sales growth to leverage

1. Economic activity measure is the (negative) change of log real GDP
2. Economic activity measure is the change in the rate of unemployment ( 100)
Table 3 Continued
One-quarter d Four-quarters d
Low-debt High-debt Low High Low High

weakening of economic activity alone predicts the increase in the sales-debt

sensitivity beyond what other macroeconomic factors would predict.
4.5. Economic interpretation
Thus far I have mostly emphasized the statistical significance of my results. Of

course, the most interesting question is whether the estimates I report imply
economically meaningful magnitudes. I describe alternative strategies to measure the
product market consequences of financial structure implied by my firm-level
estimates in turn.
In order to gauge the economic significance of the results in Table 3, first consider
the relative performance of two hypothetical firms competing in a low-debt industry.
Assume that these firms are equal in all dimensions except capital structure: One firm
has a debt-to-asset ratio 10% above the industry average ratio, while its rival has a
debt-to-asset ratio 10% below that average. Now consider the estimate of the impact
of four lags of the change of the log real GDP on the sales-debt sensitivity of firms in
low-debt industries in the multivariate specification of Panel A (=6.3). This
estimate implies that the industry-adjusted sales growth of the more indebted firm is
expected to be nearly 1.3% (=0.063 0.2) lower than that of its unlevered rival
following a 1% decline in GDP. This difference is nontrivial considering that in a
regression of quarterly industry sales growth on four lags of changes in GDP for
low-debt industries over the 1976–96 period I find that total industry sales fall by
1.2% following a 1% decline in GDP.
One can also use the results from the same specification to draw inferences about
the sales growth of similarly highly-leveraged firms competing in industries with
significantly different average debt levels. In this case, too, the imputed effect of the
shock to activity is noteworthy. Four quarters following a 1% decline in GDP, the
quarterly sales growth of the firm in the low-debt industry should underperform that
of its high-debt industry counterpart by 0.8%.
In sum, my firm-level tests show that highly-leveraged firms lose market share in
recessions (but not in booms) only in industries in which rivals are relatively
unleveraged. Recall from Section 3 that markups also fall more in low-debt
industries during recessions. These firm- and industry-level cyclical dynamics seem
consistent with Chevalier and Scharfstein’s (1996) argument that financially
constrained firms invest less in market share in low states and that the extent to
which market share is lost depends on the financial status of their industry rivals.
Also note that the firm-level results of this section cannot dismiss a state-contingent
form of the long purse story, as they suggest that unconstrained firms capture market
share from their indebted rivals in low-demand states. Finally, the nature of the time
and cross-sectional variations in performance-debt relation makes it difficult to
ascribe my findings to the industry equilibrium theories discussed in Section 2.
4.6. Robustness
To check that my conclusions do not hinge on any particular choice of lag

structure, I also estimate the above two-step procedure using two, six, and eight lags
of the right-hand side macroeconomic variables, as well as with the inclusion of
contemporaneous (lag 0) observations. All of these specifications yield qualitatively
similar results (unreported). The same applies when I use other alternative measures
of monetary policy. My conclusions also hold for various subperiods examined in
the 1976–1996 span.
My testing strategy focuses on the responses of sales-debt sensitivities to
macroeconomic shocks. I choose to emphasize the observed cross-sectional
differences in those responses (rather than their levels) because of concerns with
underlying characteristics that could influence both a firm’s debt before the recession
and its performance afterwards. On theoretical grounds, I partitioned the sample
industries according to their debt usage. However, one could argue that if product
demand is more sensitive to the level of aggregate activity in some markets than in
others, then the average debt in industries with higher (lower) demand cyclicality
should be lower (higher).20 Now suppose costs of financial distress are higher in
more cycle-sensitive industries and that the costs associated with financial distress for
the more leveraged firms in a industry include market share losses (see Opler and
Titman, 1994). Then one could observe more negative sales-debt sensitivities for high
leverage firms in low-debt industries relative to that of similarly leveraged firms in
high-debt industries following a decline in activity just because low-debt industries
are more cycle-sensitive. This alternative story suggests that my industry leverage-
based partitions could be inadvertently picking up differences in cycle sensitivities
across industries.
To verify the extent to which that story could affect my conclusions, I need to
check whether my findings on differences in sales-debt sensitivities across low- and
high-debt industries remain after controlling for cross-industry differences in the
20
This argument supposes that the cyclicality of product demand might be an industry-wide
characteristic.
cycle-sensitivity of product demand. The proxy for industry demand cycle-sensitivity

I employ follows from Sharpe (1994), who classifies industries into two groups
(‘‘durables’’ and ‘‘nondurables’’) based on the covariance between industry sales and
the GNP (see Section 3).21 I use Sharpe’s dichotomy as a conditioning variable in my
tests. The idea is as follows. Suppose the alternative story is true. Then,
unconditional comparisons between the coefficients for Sfk’s across low- and
high-debt industries would just reflect the magnitude of the differences in the
responses of sales-debt sensitivities to aggregate shocks across cycle-sensitive and
cycle-insensitive industries. Consider in turn partitioning the sample according to
whether the observations belong to cycle-sensitive or cycle-insensitive industries and
subsequently performing the two-step procedure separately for each of the
subsamples. Then, under that same competing story, the conditional comparisons
across low- and high-debt industries should yield much smaller (perhaps insignif-
icant) magnitudes for the estimated differences in Sfk’s.
Results from the multivariate version of Eq. (4) where the dependent variable is
the one-quarter dt are shown in the first (durables) and the second (nondurables)
rows of each of the two panels of Table 4. Consistent with my earlier findings, in
both subsamples, sales growth responds negatively to leverage following a negative
aggregate shock in industries in which rivals carry low debt, but not in high-debt
industries. In the durables regressions, the coefficients for the low-debt equation are
negative and statistically significant at the 3% level or better in all cases. These same
coefficients are also negative but less statistically significant in the nondurables
regressions. As before, all coefficients in the high-debt equations are insignificantly
different from zero. Most important, all of the difference coefficients in Table 4
retain the right sign, and their magnitudes are very similar to those displayed in
Table 3, demonstrating that the case for cycle-sensitivity of demand influencing
industry debt does not alter my conclusions.22
5. Concluding remarks
Recent theoretical research has proposed that capital structure can affect firm
performance in the product markets because financing arrangements can alter a
firm’s incentives (or ability) to compete. In this paper, I investigate this claim by
examining the impact of debt financing on industry markups and on firm sales
growth using data from a large cross-section of industries over a number of years.
My tests show that debt has a negative impact on relative-to-industry firm sales
growth in industries in which rivals are relatively unlevered during recessions, but
21
The durables (high GNP-sales growth covariance) subsample contains 75,423 firm-quarters in 36
different three-digit SICs, while the nondurables (low covariance) subsample contains 80,360 firm-quarters
in 35 industries.
22
A referee suggests yet another scenario: Both the industry average leverage and a firm’s deviation from
that average (i.e., its choice of a ‘‘niche’’) may be correlated with the cycle-sensitivity of demand.
Admittedly, tackling this argument would be more difficult absent a firm-level measure of demand cycle-
sensitivity.
Table 4
Sales-debt sensitivities and the business cycle: subsamples. The dependent variable is the one-quarter sensitivity of sales growth to leverage ratio [estimated
either via ordinary least squares (denote it by dOLS) or two-stage least square (d2SLS)], for firms operating in industries categorized as low- versus highly-
leveraged. In each estimation, the dependent variable is regressed on four lags of a measure of aggregate economic activity, four lags of the change in the Fed
funds rate, four lags of the change in the CPI, four lags of the change in the spread between the rates on commercial paper and the six-month T-bill, a
constant, and a time trend. The sample period is 1976:I–1996:IV. The sum of the coefficients for the four lags of the economic activity measure is shown along
with the p-value for the sum. Exclusion test rows report the p-values for the rejection of the hypothesis that the four lags of the economic activity measure do
not forecast the sensitivity of sales growth to debt. Heteroskedasticity- and autocorrelation-consistent errors are computed with a Newey and West (1987) lag
window of size four. The standard errors for the difference of the sum of the four lags of the economic activity measure are computed with a seemingly
unrelated regression (SUR) system that estimates industry group regressions jointly. Durables and nondurables industry definitions are based on Sharpe
(1994).
dOLS d2SLS
Low-debt High-debt Low High Low-debt High-debt Low High
Panel A: Economic activity measure is the (negative) change of log real GDP
1. Durables Sum of coefficients 7.606 0.713 6.894 5.824 1.022 6.846
Summation test (p-value) 0.002 0.804 0.054 0.012 0.728 0.088
Exclusion test (p-value) 0.016 0.155 0.156 0.145
2. Nondurables Sum of coefficients 2.085 3.846 5.931 2.745 5.474 8.219
Panel B: Economic activity measure is the change in the rate of unemployment ( 100)
1. Durables Sum of coefficients 15.878 6.400 9.478 8.641 3.095 5.546

2. Nondurables Sum of coefficients 3.936 5.571 9.508 6.857 13.393 20.250
375
not during booms. At the industry level, I find that markups are more
countercyclical (i.e., they increase more in recessions) when industry debt is high.
These results seem consistent with Chevalier and Scharfstein’s (1996) prediction that
financially constrained firms have greater incentives to boost short-term profits at the
expense of future sales in response to negative shocks to demand.
While results from inter-industry studies are inherently difficult to interpret, they
can provide valuable insights.23 I take my findings as evidence that capital structure
influences competitive performance in a systematic way. Overall, my results suggest
that firms’ financing choices have implications for cyclical macro dynamics, in
general, and for the dynamics of strategic interactions in product markets, in
particular. This paper contributes to the literature in suggesting that those dynamics
should be accounted for in future work by both macroeconomists and financial
economists.
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Capital Structure and Product Markets Interactions Evidence From Business Cycles

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Capital Structure and Product Markets Interactions Evidence From Business Cycles

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Journal of Financial Economics 68 (2003) 353–378

Capital structure and product markets

JEL classification: G32; D43; E32

2. Financial structure and product markets: some theories and hypotheses

3. Industry-level evidence on markup movements over the business cycle

3.1. Data and methodology

Detailed industry-level data are typically compiled by governmental agencies and

20 Foods 0.26 0.03 83.38 0.90 34.50 Nondurable

38 Instruments 0.19 0.03 N/A N/A 47.80 Nondurable

N/A: Not available.

The ﬁrst estimation reported in Table 2 examines whether markups are

3.3. Interpretation and robustness

1. OLS 10.0764 0.046 924

4. Firm-level evidence on market share building over the business cycle

The endogeneity of financing decisions at the firm level makes it difficult to

I ﬁnd that periods surrounding shocks to aggregate demand provide the

4.2. Measuring firm performance

In examining the interactions between product markets and capital structure,

4.3. Estimation methodology

4.3.1. A two-step procedure

4.3.2. Cross-industry comparisons

Fig. 1 provides descriptive evidence of remarkably distinct dynamics for the

Low-debt industries High-debt industries

Low-debt High-debt Low High Low High

Panel A: Dependent variable is the OLS-estimated sensitivity of sales growth to leverage

2. Economic activity measure is the change in the rate of unemployment (  100)

Panel B: Dependent variable is the 2SLS-estimated sensitivity of sales growth to leverage

Low-debt High-debt Low High Low High

Univariate Sum of coefﬁcients 6.125 0.268 5.857 36.139

weakening of economic activity alone predicts the increase in the sales-debt

4.5. Economic interpretation

Thus far I have mostly emphasized the statistical signiﬁcance of my results. Of

To check that my conclusions do not hinge on any particular choice of lag

cycle-sensitivity of product demand. The proxy for industry demand cycle-sensitivity

Low-debt High-debt Low High Low-debt High-debt Low High

Exclusion test (p-value) 0.000 0.421 0.076 0.311

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2. Economic activity measure is the change in the rate of unemployment ( 100)