Leverage Changes and Product Pricing Incentives -- A Tax Induced Analysis

Abstract

This paper provides a tax induced framework which can explain the linkage between pricing policies and capital structure choice documented in recent studies by Chevalier (1995a), (1995b) and Phillips (1995). The model proves that firms will optimally change their pricing decisions after taking on additional debt. The reason is that the value of debt related tax shelters and the probability of their use is dependent on revenues realized in the product market. The direction of change is shown to depend on several variables, importantly the elasticity of demand for the firm's product. In an ensuing section, the paper extends the analysis to provide some insights into the impact of pricing choices on the promised yield of debt.