Abstract - Acquisition Values and Optimal Financial (In)Flexibility

We analyze optimal financial structure for an incumbent and potential entrant accounting for
feedback effects in secondary asset markets. By issuing sufficient debt, the incumbent creates
overhang and credibly commits against acquiring entrant assets. This depresses asset values
and entrant returns, thus reducing the likelihood of entry. The cost of debt overhang is that
the incumbent fails to make positive NPV acquisitions if entry deterrence fails. The implied trade-off between ex post efficiency and entry deterrence explains why growth firms eschew debt
while value firms issue public debt. Contrary to the traditional view, if predation is feasible,
the case for shallow pockets is potentially stronger, since an unlevered incumbent prefers to
acquire whereas a levered incumbent responds to entry with predation. Since predation reduces
entrant returns and acquisitions raise them, the entry deterrence benefit from shallow pockets is
magnified if predation is feasible. Optimal entrant contracts depend upon incumbent financial
structure, with higher debt capacity and stronger financier ownership rights if the incumbent has
deep pockets.

Ulrich Hege(speaker), Christopher Hennessy
HEC School of Management (Paris)
22.Jan 2008

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