Capital Structure, Compensation and Incentives

This article illustrates an incentive-aligning role of debt in the presence of optimal compensation contracts. Owing to information asymmetry, value-maximizing compensation contracts allow managerial rents following high investment outcomes. The manager has an incentive to increase these rents by ch...

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Bibliographic Details
Published in:The Review of financial studies 2006-07, Vol.19 (2), p.605-632
Main Author: Douglas, Alan V. S.
Format: Article
Language:English
Subjects:
Asset management
Asymmetric information
Asymmetry
Capital management
Capital structure
Cash flow
Cash flow forecasting
Compensation
Contract incentives
Contracts
Correlation analysis
Debt
Debt management
Economic models
Financial economics
Financial leverage
Financial management
Incentives
Investment strategies
Leverage
Microeconomics
Pay for performance
Shareholders
Stockholders
Strategic planning
Studies
Volatility
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Summary:This article illustrates an incentive-aligning role of debt in the presence of optimal compensation contracts. Owing to information asymmetry, value-maximizing compensation contracts allow managerial rents following high investment outcomes. The manager has an incentive to increase these rents by choosing investments that generate greater information asymmetry. An aptly chosen debt level mitigates this incentive, because investments that generate greater information asymmetry have more volatile outcomes. The greater volatility would make the debt risky, causing the shareholders to focus on high outcomes and therefore compensation contracts that reduce managerial rents. At the optimum, the manager avoids opportunistic investments, and the shareholders offer value-maximizing compensation contracts. Empirically, the analysis predicts a negative relationship between leverage and market-to-book that is reversed at extreme market-to-book ratios, a negative relationship between leverage and profitability, a negative relationship between leverage and pay-for-performance, and a positive relationship between pay-for-performance and investment opportunities.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhj010