Since Modigliani and Miller (1958), financial economists have devoted much effort to understanding firms' financing policies. While most of the early literature analyzes financing decisions within qualitative models, recent research tries to provide quantitative guidance as well. This is typically done in contingent claims models in which the firm's investment policy is fixed and the value0maximizing debt level results from a trade off between tax benefits and costs of financial distress. When applied to capital structure decisions, contingent claims models generally suffer from two major limitations. First, these models generate leverage ratios that exceed observed leverage ratios. Second, they cannot reproduce the cross sectional variation in capital structures. One potential explanation for these limitations is that these models have overlooked some determinants of debt policy in particular the impact of agency conflicts on firms' financing decisions.
The notion that agency conflicts affect firms' investment and financing decisions is now widely accepted. While agency conflicts can take a variety of forms, the literature analyzing corporate securities as contingent claims has more narrowly focused on share holders' incentives to increase investment risk the asset substitution problem or to reject positive NPV projects the underinvestment problem. Because the costs associated with these conflicts typically increase with the firm's leverage and with the number of growth options available to the firm, it has been argued that these conflicts could explain both observed debt levels and the cross0sectional variation in capital structures [see e.g. Smith and Watts (1992)]. However, recent work by Leland (1998) or Parrino and Weisbach (1999) has shown that distortions arising from stockholder bondholder conflicts are typically too small to explain firms' capital structure decisions.
Another agency cost that has received a lot of attention in the corporate finance literature is the cost that arises from conflicts of interests between controlling and minority shareholders. In most countries, publicly traded companies are not widely held, but rather have controlling shareholders. Moreover, these controlling shareholders have the power to pursue private benefits at the expense of minority shareholders, within the limits imposed by investor protection. The recent law and finance literature following Shleifer and Vishny (1997) and La Porta et al. (1998) argues that the expropriation of minority shareholders by the controlling shareholder is at the core of agency conflicts in most countries. While these conflicts have been widely discussed in qualitative terms, the literature has largely been silent on the magnitude of their effects. As illustrated by the analyses of Leland (1998) and Parrino and Weisbach (1999), the importance of these ideas ultimately depends on the magnitude of the underlying conflicts and their ability to explain firms' policy choices.
This paper builds a contingent claims model that addresses both of these questions. We consider a setting in which a firm is set up by a controlling shareholder, also referred to as the entrepreneur. At any date, this entrepreneur can divert part of the firm's cash flows as private benefits at the expense of minority shareholders [as in La Porta et al. (2002)]. In this environment, we examine the impact of the opportunistic behavior of the entrepreneur on the firm's investment and financing decisions. For doing so, we follow Zwiebel (1996) by presuming that the entrepreneur has control rights over the firm's investment and financing policies. In the paper, the firm can issue both debt and equity. Once debt has been issued, the entrepreneur selects the exercise strategies for shareholders' option to default and the firm's growth options. Based on this endogenous modeling of default and investment decisions, the paper derives valuation formulas for corporate debt and equity. These expressions are then used to analyze the interaction between investment and financing policies and determine the firm's capital structure.
In the paper, conflicts of interests between the entrepreneur and minority shareholders are associated with two types of deviations from value maximization. First, the entrepreneur diverts part of the firm's cash flows as private benefits. Second, he invests early in the firm's growth options. By reducing the firm's net cash flow, debt financing reduces both distortions and increases firm value. Two possible conclusions emerge from this observation. First, the debt level that maximizes firm value increases with the distortions implied by conflicts of interests among shareholders. Second, when the entrepreneur has discretion over financing policy, the selected leverage ratio is lower than the value maximizing one. As shown in the paper, this allocation of control rights is essential in generating debt levels that are consistent with observed debt levels. The analysis in the paper also demonstrates that when investment policy is endogenous, the number of growth options in the firm's investment opportunity set has a large impact on financing decisions. In particular, as the number of growth options rises, the cost of underinvestment increases and the selected debt level decreases, thereby generating the desired cross sectional variation in leverage.
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Capital Structure, Investment, and Private Benefits of Control
