Abstract

http://ssrn.com/abstract=1102196
 


 



Managerial Compensation and Capital Structure Under Asymmetric Information


Kostas Koufopoulos


University of Warwick - Finance Group



Abstract:     
We consider firm financing when the firm quality is private information of the manager and, given its inherent quality, the project viability depends on the manager exerting unobservable effort. We show that capital structure matters even though managerial contracts are optimally designed. Good firms would like to issue more debt to avoid selling underpricing equity. However, the interaction between managerial compensation and leverage does not allow them to do so. Because debt is senior to (the performance-related part of) managerial compensation, a high leverage prevents the implementation of the optimal managerial contract and so it destroys effort incentives. Therefore, we provide an explanation of why good firms appear to use debt conservatively and issue both debt and underpriced equity (even if the bankruptcy and agency costs of debt are zero). We also show that the optimal financial contract can be implemented by a combination of debt and equity.

Our results have also some interesting empirical implications: i) They are consistent with the well-documented negative relation between leverage and profitability. ii) Our model predicts that the higher the proportion of low-profitability (bad) firms, the higher the fraction of funds raised through equity. This prediction is consistent with the findings in Fama and French (2005).

Keywords: Asymmetric Information, Capital Structure, Managerial Compensation

JEL Classification: D82, G32

working papers series


Not Available For Download

Date posted: March 13, 2008  

Suggested Citation

Koufopoulos, Kostas, Managerial Compensation and Capital Structure Under Asymmetric Information. Available at SSRN: http://ssrn.com/abstract=1102196 or http://dx.doi.org/10.2139/ssrn.1102196

Contact Information

Kostas Koufopoulos (Contact Author)
University of Warwick - Finance Group ( email )
Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain
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