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Real and Financial Decisions in Mergers

Both real and financial variables are integrated into a model of oligopolistic firms that allows for mergers. Limited liability provides the basis for financing mergers by means of debt. This shifts risk to credit holders in bad states of nature. In general, it is found that when the credit market clears, the cost of credit to the firm increases with the amount of debt issued. Moreover, if all agents are risk neutral no debt is issued; the merger is financed only by equity. But allowing the merged firm to be risk averse does yield nonnegative debt, depending on its cost and its strategic effect. Simulations of a special form of the general model help explain the change in capital structure from the high debt-equity ratios in the 1980's and the low debt-equity ratios associated with mergers in the 1990's. These explanations make explicit the role played by changes in risk aversion as a result of the increased institutional presence in the 1990's equity market, the increase in product market volatility, and the increase in competition. We also indicate what did not contribute to the change in the capital structure in the two decades.