Much has been learned from models in which managers, whose interests diverge from those of financiers, undertake various actions, including the design of control rights (e.g., Aghion and Bolton (1992)), and Masulis and Nahata (2010), choice of securities to raise financing (e.g., Hart and Moore (1995)), and the determination of capital structure (e.g., Grossman and Hart (1982) and Jensen and Meckling (1976)). Yet, there is much we do not know when it comes to security issuance and capital structure, as recent empirical research has uncovered a host of puzzling stylized facts like the sluggishness of firms in making capital structure adjustments in response to stock price movements.
Moreover, the viewpoint that managers are driven exclusively by narrow self interest misses out on the opportunity to examine the corporate finance ramifications of the behavior of managers whose objectives are aligned with those of the shareholders, due to sufficiently high stock ownership (as in the case of say Bill Gates or Warren Buffett), intrinsic motivation (e.g., Van den Steen (2005)), or matched “mission preferences” (e.g., Besley and Ghatak (2005)). There is thus the need for a fresh perspective.
Of course, if managers always do what all shareholders desire, the problem of separation of ownership and control is rendered sterile. We therefore study a manager who seeks to maximize initial shareholder wealth, but who has a potentially “different model of the world.” In particular, the manager and investors who purchase the firm’s securities have different beliefs about the precision of a commonly-observed prior signal about a project, which leads to potential disagreement over project choice.
While assuming heterogeneous priors departs from the standard common priors assumption, we note that rationality only restricts the revision of prior beliefs to be Bayesian, without addressing where these prior beliefs come from. Priors are taken as part of the primitives, along with preferences and endowments. Our assumption is consistent with Kurz’s (1994a, b) theory of “rational beliefs” in which different beliefs are admissible as long as they do not conflict with historical data.
The question we address within this framework is: how do the initial owners of the firm, whose objectives and beliefs are congruent with those of the manager, design shareholder and bondholder control rights for new investors whose beliefs may differ, and how do these interact with the manager’s capital structure decisions? The theory we develop to address this question illuminates many puzzling stylized facts about capital structure and pivots on the concept of managerial autonomy. Simply put, autonomy is the ability of the manager to make investment decisions he thinks are best even when investors disagree. The manager is endogenously shown to value this autonomy because it enhances his ability to maximize shareholder wealth.
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Managerial Autonomy, Allocation Of Control Rights And Optimal Capital Structure
