Durability, Indirect Bankruptcy Costs, and Capital Structure

I contribute to the literature by formally modeling the indirect bankruptcy costs for a firm that sells durable goods. Consumers concerned about warranties or future product services penalize the distressed firm by putting off purchases or leaving the market. Subsequent lower demand of durable goods generates lower cashflows for the firm, and these lost profits are larger if the firm produces more durable goods. In a parsimonious framework, I show that the loss in profitability (i.e., indirect bankruptcy costs) significantly lowers the firm’s demand for leverage. I also acknowledge that there is an innate consumer demand for durability (i.e., useful life of a product) and show that the firm supplies lower durability than the market demands. Other than the cost of producing durable goods, indirect bankruptcy costs limit the firm’s choice of durability. Finally, I also show that if the firm has a valuable innovation option, it exercises the option sooner to offset bankruptcy costs of durability.