A Model of Dynamic Compensation and Capital Structure
University of Chicago - Booth School of Business, and NBER
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
Date posted: March 18, 2008 ; Last revised: July 15, 2010