1. Capital Structure and competitiON
P.V. Viswanath
MBA 673, Financial Theory and Strategic Decision-Making

2. Game Theory
Game theory is the study of strategic decision making. More formally, it is the study of mathematical models of conflict and cooperation between intelligent rational decision-makers.
Game Theory is used to analyze how firms interact but has many other applications.
(Some slides taken from Michael Conlin, online and Mike Shor.)

3. Game Theory Terminology
In game theory, a strategy is a decision rule that describes the actions a player will take at each decision point.
A representation of a game indicating the players, their possible strategies, and the payoffs resulting from alternative strategies, called Normal Form Game is usually used to represent simple games.
Let’s see how this works with a prisoner’s dilemma, presented as a normal form game.

4. Example 1: Prisoner’s Dilemma (Normal Form of Simultaneous Move Game)
Martha’s options
Don’t Confess
Confess
Peter’s Options
M: 2 years
P: 2 years
M: 1 year
P: 10 years
M: 10 years
P: 1 year
M: 6 years
P: 6 years
What is Peter’s best option if Martha doesn’t confess?
Confess (1<2)
What is Peter’s best option if Martha confess?
Confess (6<10)
A dominant strategy that is optimal independent of what the opponent’s does

5. Example 2: Price Setting Game
Firm B’s options
Low Price
High Price
Firm A’s Options
0 , 0
50 , -10
-10 , 50
10 , 10
Is there a dominant strategy for Firm B?
Low Price
Is there a dominant strategy for Firm A?
Low Price

6. Nash Equilibrium
If both players have dominant strategies, then that pair of dominant strategies will most likely be the equilibrium outcome. But what if there are no mutually dominant strategies?
For such a case, John Nash, came up with an equilibrium which, he suggested, could describe outcomes. This is called a Nash equilibrium.
A Nash equilibrium is a condition describing a set of strategies in which no player can improve her payoff by unilaterally changing her own strategy, given the other player’s strategy.
In other words, every player is doing the best they possibly can given the other player’s strategy.
If a pair of dominant strategies exist, the equilibrium consisting of those two strategies will also be Nash, but not all Nash equilibria correspond to dominant strategies.
Nash equilibria don’t always exist for a given game, but if they do, then there is a strong argument that that would describe the actual outcome of the game.
(But sometimes there can be more than one Nash equilibrium!)

7. Example 1: Nash? One Nash Equilibrium is: (Confess, Confess)
Martha’s options
Don’t Confess
Confess
Peter’s Options
2 years , 2 years
10 years , 1 year
1 year , 10 years
6 years , 6 years
One Nash Equilibrium is: (Confess, Confess)
Are there any other Nash equilibria?

8. Example 2: Nash? Nash Equilibrium: (Low Price, Low Price)
Firm B’s options
Low Price
High Price
Firm A’s Options
0 , 0
50 , -10
-10 , 50
10 , 10
Nash Equilibrium: (Low Price, Low Price)
Are there any other Nash equilibria?

9. Example 3: New Technology
Firm B’s options
New Technology
Stay Put
Firm A’s Options
0 , 0
50 , -50
-50 , 50
Is there more than one Nash equilibrium?

10. Example 4: Making Deals Director’s options Yes No Movie Star’s Options
50 , 50
0 , 0
Is there more than one Nash equilibrium?

11. Example 4: video systems
Firm 2’s options
Betamax
VHS
Firm 1’s Options
50 , 50
0 , 0
40 , 40
Is there more than one Nash equilibrium?

12. Commitment games
We will now look at some games and examine the role of involvement, commitment, and other devices in the resolution of uncertainty in these games.

13. Involvement, Commitment and Strategy
Consider the following chicken game:
Manny
Danny
Swerve
Straight
Tie, Tie
Lose, Win
Win, Lose
Crash, Crash
Because the loss from swerving is so trivial compared to the crash that occurs if nobody swerves, the reasonable strategy would seem to be to swerve before a crash happens. Yet, knowing this, if one believes one's opponent to be reasonable, one may well decide not to swerve at all, in the belief that he will be reasonable and decide to swerve, leaving the other player the winner.
This game has no symmetric Nash equilibrium in pure strategies. If Manny is going to swerve, then Danny should go straight. If Manny is going to go straight, then Danny should swerve (assuming losing is better than crashing).
In other words, there is unresolvable uncertainty in this game, as currently stated.
How can the uncertainty be resolved?

14. Commitment and Strategy
One tactic in the game is for one party to signal their intentions convincingly before the game begins. For example, if one party, say Danny, were to ostentatiously disable their steering wheel just before the match, the other party would be compelled to swerve.
This shows that, in some circumstances, reducing one's own options can be a good strategy.
Manny
Danny
Swerve
Straight
Win, Lose
Crash, Crash
Source: Wikipedia

15. Commitment and Strategy
One real-world example is a protester who handcuffs himself to an object, so that no threat can be made which would compel him to move (since he cannot move).
Another example, taken from fiction, is found in Stanley Kubrick's Dr. Strangelove. In that film, the Russians sought to deter American attack by building a "doomsday machine," a device that would trigger world annihilation if Russia was hit by nuclear weapons or if any attempt were made to disarm it. However, the Russians failed to signal—they deployed their doomsday machine covertly.
Obviously, this will not elicit the desired response from the opponent, i.e. backing down. Revelation of the signal is key.
Source: Wikipedia

16. Commitment vs. Involvement
Two firms considering market entry:
Market potential is $10 million NPV profits
Entry costs $7 million; if both enter, both firms lose.
It is in our best interest to stay out if we think that the other firm will enter.
So this is like the chicken game.
Them In
Out Us
-2 , -2
3 , 0
0 , 3
0 , 0
Mike Shor
Game Theory & Business Strategy

17. Involvement Them In Out Us -2 , -2 3 , 0 -1 , 3 -1 , 0
How can we strategically resolve this uncertainty?
Consider making a small initial investment:
Invest first $1 million to deter entry, which is lost if we then quit.
It is still in our best interest to stay out if we think that the other firm will enter.
This level of involvement is insufficient: we still have uncertainty that remains unresolved .
Them In
Out Us
-2 , -2
3 , 0
-1 , 3
-1 , 0
Mike Shor
Game Theory & Business Strategy

18. CREDIBLE Commitment Them In Out Us -2 , -2 3 , 0 -3 , 3 -3 , 0
Now suppose we make a larger initial investment:
Invest first $3 million to deter entry, which amount is lost if we then quit.
Now, it is our dominant strategy to enter regardless of what the other firm will do.
By reducing our own payoffs from staying out, we have committed to entry.
This is like a first-mover advantage.
Them In
Out Us
-2 , -2
3 , 0
-3 , 3
-3 , 0
Mike Shor
Game Theory & Business Strategy

19. Reducing Payoffs: Contracting
Consider another example of a credible commitment.
Suppose you don’t want to pay more than $200 million for an acquisition target.
It is known that you can “afford” payments of $20 million/yr. for 20 years; if the interest rate is 7%, this means that you can afford $211.88m (PV of $20/yr. for 20 years at 7%). How can you hold out for $200m.?

20. Reducing payoffs How many Nash equilibria are there in this case?
Demand
$200m
Demand $210m
Acquirer
Pay $200m
$10, $10
$0, $0
Pay $210m
$0, $20
$0 , $20

21. Reducing Payoffs: Contracting
Suppose you enter into a binding contract to finance the takeover for 20 years at 7%. But…
Add penalty: if amount greater than $200 million, +1.5 points on interest rate
Price Annual Payments:
$200 million: $18.8 million / year
$210 million: $19.82 million / year – still affordable
But with penalty: $22.19 million / year -- unaffordable
The present value of the higher payments is $236m.
So it’s clear that the acquirer will not pay more than $200m.
This is, therefore, a credible commitment.

22. Reducing payoffs How can we strategically resolve this uncertainty?
Consider making a small initial investment:
Invest first $1 million to deter entry, which is lost if we then quit.
Target
Demand
$200m
Demand $210m
Acquirer
Pay $200m
$10, $10
$0, $0
Pay $210m
-$26, $20
Mike Shor
Game Theory & Business Strategy

23. Commitment and Managerial behavior
Here’s another example of how commitment can help.
It is well known that managers have an incentive to take negative NPV projects if they have private benefits (from perks) from firm investment.
For example, a manager might authorize the purchase of a company jet for business travel, if he himself were using the jet, whereas he might not if it were for the use of other company personnel.
Knowing that such incentives for inappropriate use of company resources exist, outside investors, both equity and debt, may be discouraged from putting their money in the firm.
Good employees, too, may decide not to work for a firm, where such potential exists; or, at the very least, they may decide not to make any personal sacrifices for the firm.
How could a firm solve this problem?

24. Commitment and Managerial behavior
One solution is for the firm to take on debt. The existence of debt means that managers have a greater incentive to choose profitable projects.
The reason is that every choice of an unprofitable project increases the probability of bankruptcy to a greater degree for a leveraged firm. Bankruptcy, and possibly liquidation. And in such a case, managers would lose their firm-specific human capital.
In brief, Investors/employees have reason to worry about suboptimal actions by management; to counteract this, managers can use debt as a commitment device. By taking on debt, managers commit to take on profitable projects.
This is the basis for Michael Jensen’s Free Cashflow Hypothesis.
Another solution is to promote a corporate culture where people who are more willing to work for the common good. Hiring only people who buy into such a corporate culture could deliver the same outcome without the costs of excessive leverage.

25. Debt, human capital and Risk- taking
So if debt might cause managers to have a greater preference for positive NPV projects, what about the tendency of firms to take excessive risk?
Is this still true, if we introduce managers into the picture?

26. Leverage and competitive strategy
We now need to look at how capital structure can be used to enhance competitive strategy in a world where competitors are aware of the effects of capital structure on the behavior of managers.
We have seen that there are three different consequences of leverage – risk-seeking behavior, myopia and underinvestment.
We will now look at the competitive implications of those consequences.