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A Model of Dynamic Compensation and Capital Structure

Zhiguo He

University of Chicago - Booth School of Business

April 19, 2010

AFA 2009 San Francisco Meetings Paper
Journal of Financial Economics (JFE), Forthcoming

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

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Date posted: March 18, 2008 ; Last revised: July 15, 2010

Suggested Citation

He, Zhiguo, A Model of Dynamic Compensation and Capital Structure (April 19, 2010). AFA 2009 San Francisco Meetings Paper; Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: http://ssrn.com/abstract=1107019 or http://dx.doi.org/10.2139/ssrn.1107019

Contact Information

Zhiguo He (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 South Woodlawn Avenue
Chicago, IL 60637
United States
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