Capital Structure and the Design of Managerial Compensation
Posted: 3 Aug 1999
Date Written: July 1994
This paper provides an optimal design of managerial compensation in the presence of an exogenous capital structure with its associated debt agency costs. The model entails the analysis of a three-party conflict between debtholders, equity holders, and management. Equityholders, as principals owning a production technology, design a compensation contract for managers. Management is engaged solely in the choice of project risk with risky return outcomes along a production frontier. It is shown that, in the absence of debt, risk averse managers would tend to risk-shift downwards, realizing suboptimal firm value. In the presence of a senior debt claim equity holders find it advantageous to choose higher risk projects and it is possible that for sufficiently high debt levels, the agency costs of debt and managerial risk aversion counterbalance each other, with the final outcome coinciding with first best risk choices. The empirical relationship between capital structure and compensation is also studied, as are the implications of debt and risk aversion for the pay- performance relations.
JEL Classification: J33
Suggested Citation: Suggested Citation