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Relationship between market power, leverage and systematic risk : the Canadian evidence Chan, Adrian Seng Giap

Abstract

A number of studies demonstrated a positive relationship between market power and firm profitability. Economic theory demonstrates that these high profits imply higher prices and restricted output and consequently inefficient resurce allocation. Financial leverage, however, could be a possible alternative explanation for these profits. Market power may increase the ability of firms to support low cost debt capital and therefore the higher observed profitability could also be the result of greater financial leverage. This study then attempted to find empirical evidence to support the hypothesis that there is no significant difference between the financial structures of powerful firms and other less powerful firms. Leverage should increase risk because it represents a fixed obligation to the firm. The method of study employed is the application of analysis of variance and regression analysis to a cross-sectional sample of Canadian industry during the period 1962 to 1969. This study represents a first attempt to apply a finance model viz. CAPM to a problem in industrial organization, viz.concentration. The results indicate that powerful firms have relatively lower debt than other less powerful firms, thus rejecting the hypothesis. As a result of lower debt, powerful firms incur lower risk. The firm with market power apparently prefer low risk and a conservative capital structure.

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