A Model of Dynamic Compensation and Capital Structure

Abstract:     
This paper studies the optimal compensation problem between shareholders and the agent in a general cash-flow setup, and offers a framework to quantitatively assess the impact of agency problems. Under the structural model of capital structure studied in Leland (1994), we find that the debt-overhang effect on the endogenous managerial incentives lowers the optimal leverage. Consistent with the data, our model delivers a negative relation between pay-performance sensitivity and firm size, and the interaction between debt-overhang and agency issue leads smaller firms to take less leverage relative to their larger peers. During financial distress, a firm's cash-flow becomes more sensitive to underlying performance shocks due to debt-overhang. The implications on credit spreads and debt covenants are also considered.

Number of Pages in PDF File: 40

Keywords: Continuous-time Contracting, Capital Structure, CARA (Exponential) Preference, Firm Growth, Size-Heterogeneity, Pay-Performance Sensitivity.

JEL Classification: C73, G32, J33, D82

working papers series