The Effect of Leverage on Implicit Incentive Contracts

6th Annual Texas Finance Festival

26 Pages Posted: 31 Aug 2004

Date Written: April 11, 2004


In the context of an infinitely-repeated principal-agent problem with hidden information, I examine the effect of long-term debt on implicit (relational) contracts between the firm and employees/suppliers. Implicit contracts rely on the promise of future surplus as an incentive for parties to fulfill obligations. Long-term debt reduces the discounted value of bilateral surplus accruing to the principal and agent, monotonically compressing the set of credible self-enforcing bonus schedules. Moderate (high) leverage results in partial (complete) pooling. With positive debt, the agent's output is always below first-best. In the event of complete pooling, output for all types is below first-best for even the highest cost type.

Suggested Citation

Hennessy, Christopher, The Effect of Leverage on Implicit Incentive Contracts (April 11, 2004). 6th Annual Texas Finance Festival. Available at SSRN: or

Christopher Hennessy (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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