Hypothesis Development

We invoke two non-mutually exclusive theories of capital structure to explain the leverage relationship between a supplier and its customer: the bargaining theory and the relation-specific investment theory. In this section, we first review the literature on these two theories and develop testable hypotheses according to the implications of the theories. We then briefly review other closely related literature.

Leverage and Bargaining Power

Bronars and Deere [1991] argue that firms can use debt as a bargaining tool to reduce the surplus that labor unions can extract. They also empirically show that firms facing a greater threat of unionization use debt more aggressively. Dasgupta and Sengupta [1993] develop a bargaining model to show that debt improves a firm’s bargaining power against its employees or suppliers. Hennessy and Livdan [2009] put the supplier-customer relationship within a relational contract framework and show that debt decreases the amount of surplus the suppliers can extract, and thereby increases the firm’s bargaining power against its suppliers. Empirically, Kale and Shahrur [2007] find that when a firm’s customers or suppliers have higher bargaining power (measured by the industry Herfindahl index), the firm tends to have higher leverage. Matsa [2010] also find that firms with higher labor union coverage use higher leverage. The above-mentioned literature all suggests that debt improves a firm’s bargaining power against its employees, customers or suppliers. Thus, what does the bargaining theory imply about the leverage relationship between suppliers and customers?

According to the bargaining theory, when the customer increases its leverage, it increases its bargaining power against its supplier. The supplier, unwilling to lose its bargaining power, then responds by increasing its own leverage to improve its bargaining power. Therefore, the bargaining theory suggests that the supplier’s leverage and its customer’s leverage should be positively associated. Furthermore, the bargaining theory also suggests that the leverage relationship is likely to be affected by the ex-ante bargaining power of the supplier and the customer. If the customer has a higherex-ante bargaining power and increases its leverage, its supplier will find itself in a much worse bargaining position and will, therefore, increase its leverage more aggressively. As a result, the positive leverage relationship becomes stronger if the customer has more bargaining power. We summarize below two hypotheses based

on the bargaining theory.

Hypothesis 1A: According to the bargaining theory of capital structure, a sup- plier’s leverage is positively associated with its customer’s leverage.

Hypothesis 1B: The positive leverage relationship between a supplier and its customer is stronger if the customer has more ex-ante bargaining power.

Because the way in which the ex-ante bargaining power affects the leverage re- lationship depends on whether the leverage relationship is positive or negative, we have a different version of Hypothesis 1B in case of a negative leverage relationship:

Hypothesis 1C: The negative leverage relationship between the supplier and its customer is weaker if the customer has more ex-ante bargaining power.

Leverage and Relation-Specific Investments

Titman [1984] shows that a firm’s liquidation policy can affect its customer’s welfare and that the firm can commit to a liquidation policy by choosing a lower leverage. Im- plicit in Titman’ analysis is that the customer makes relation-specific investments and that these investments lose value once the firm goes into liquidation. Maksimovic and Titman [1991] further show that high leverage reduces a firm’s incentive to invest in its reputation and product quality. More recently, Hennessy and Livdan [2009] study the effect of leverage on relation-specific investments from a different perspective. They show that high leverage reduces a firm’s ability to pay the suppliers incentive payments to make relation-specific investments. Based on these theoretical insights, Kale and Shahrur [2007] find that firms lower their leverage to induce suppliers and customers to make relation-specific investments. In summary, the relation-specific investment theory suggests that a firm’s leverage reduces its customer’s incentive to make relation-specific investments, and the firm, therefore, chooses lower leverage to induce its customers to make efficient investments. What does the relation-specific investment theory of leverage imply about the leverage relationship between the sup-

plier and its customer?

To fix the idea, we consider the case in which the customer has increased its leverage for some exogenous reasons. On one hand, according to the relationship- specific investment theory, the customer’s high leverage will decrease the supplier’s relationship-specific investments. On the other hand, according to the under-investment theory of Myers [1977], the customer’s high leverage will also decrease the customer’s own investment, which may also include customer’s relationship-specific investment to the supply chain. Consequently, to mitigate such investment inefficiencies caused by customer’s high leverage, the supplier can respond by reducing his own lever- age, which, according to the relationship-specific investment theory, will increase the customer’s relationship-specific investment, and according to the under-investment theory, will increase the supplier’s own investment. The above discussion, therefore, suggests a negative relationship between the supplier and customer leverages.

Hypothesis 2A: According to the relation-specific investment theory of capital structure, a supplier’s leverage is negatively associated with its customer’s leverage.

Hypothesis 2B: The negative leverage relationship between a supplier and its customer is stronger if the relation-specific investments are more important.

Because the way in which the importance of relation-specific investments affects the leverage relationship depends on whether the leverage relationship is positive or negative, we have a different version of Hypothesis 2B for the case of a positive leverage relationship:

Hypothesis 2C: The positive leverage relationship between the supplier and its customer is weaker if relation-specific investments are more important.