The issue of aligning managerial interests with those of the owners is important and has received considerable attention in the economics and finance literature. The traditional tool for aligning these interests has been managerial compensation contracts. However, it is increasingly recognized, especially in the finance literature, that the firm's capital structure, that is, the proportion of debt financing, also has a bearing on the manager's incentive to act in the owners interest.
For example, Jensen, 1986 argues that debt may provide a useful tool to discipline managers by restricting the amount of free cash flow in their control. In addition, it is well-known that managers incur pecuniary and non-pecuniary costs in bankruptcy states associated with debt. These effects of debt on managerial payoffs suggest that managerial compensation contracts should be different with debt than without. Given that firms borrow, the design of compensation contracts as well as the choice of debt ought to take into account the relationship between the two.
In this paper, we study the effect of debt on managerial compensation contracts and learning, in adynamic context. That is, we ask how the compensation contract with debt compares with the compensation contract without debt. In particular, is debt a substitute for compensation, implying for example that the presence of debt leads to a lower compensation fora given performance level? How does debt affect the pay-performance sensitivity? Further, if managerial abilities are unknown, how does debt affect the learning process? Finally, how do these effects of debt on compensation feedback into the choice of debt? In particular, if debt has no other benefits and costs, does its effect on compensation lead to a positive debt level in equilibrium?
The motivation for studying hidden abilities and learning is straightforward. Asymmetric information characterizes contractual relationships among various agents participating in the firm's activities and is at the heart of the agency theory. If adverse selection exists, managers with superior abilities find it easier to shirk or equivalently consume more perquisites if these actions are unobservable and/or there is uncertainty in the outcomes. Thus compensation contracts need to address not only the problem of inducing the optimal effort level fora manager with known ability but also the problem of inducing the optimal effort from the manager given that his ability is unknown. In this paper, we concentrate on the latter problem in adynamic setting.
