Dynamic Capital Structure Under Managerial Entrenchment: Evidence from a Structural Estimation

Abstract:     
This paper examines the impact of agency conflicts on corporate financing decisions. We first build a dynamic contingent claims model in which financing policy results from a trade-off between tax benefits, contracting frictions, and agency conflicts. In our setting, partially-entrenched managers set the firms' payout and financing policies to maximize the present value of their rents. Shareholders can remove managers, but only at a cost. Our analysis demonstrates that entrenched managers issue less debt and rebalance capital structure less often than optimal for shareholders. We then use structural econometrics to provide firm-specific estimates of the degree of managerial entrenchment. We find that costs of control challenges of 2% of equity value on average are sufficient to resolve the low- and zero-leverage puzzles and explain the time series of observed leverage ratios. Our estimates of the agency costs also reveal that governance mechanisms significantly affect the value of control and firms' financing decisions.

Keywords: dynamic capital structure, managerial entrenchment, structural estimation

JEL Classifications: G12, G31, G32, G34

Working Paper Series