This paper embeds optimal contracting between the agent (manager) and shareholders into the cash flow framework commonly used in the literature of structural models of capital structure (Leland, 1994). By connecting these two literatures, I provide a general framework to study the impact of agency characteristics on firm valuation and capital structure. Moreover, the dynamic nature of this framework allows me to calibrate my model and, in turn, quantitatively assess the agency impact on the firm’s leverage decision.
I characterize the optimal contract between shareholders and the agent explicitly. In determining the leverage level, debt bears an additional “debt overhang” cost relative to the bankruptcy cost in standard models (a la Leland, 1994): By interpreting the agent’s effort as a form of investment, shareholders implement diminishing effort (as cut back investment) during financial distress. As a result, the agency problem reduces the optimal leverage from 63.2% based on Leland (1994, with my calibration) to as low as 39.5%. Consistent with the data, my model predicts that small firms take less leverage relative to their large peers. The debt-overhang problem also implies that the firm’s cash flow is more sensitive to underlying shocks, reinforcing the standard leverage effect.
Section 2 starts by offering a general analysis in solving the optimal contracting problem. The analysis hinges on the agent’s constant absolute risk aversion (CARA, or exponential) preference. In contrast to Holmstrom and Milgrom (1987), in which the lump-sum compensation is considered, the agent in my model has intermediate consumption flows and can privately save. To solve for the optimal contract, I employ the approach in Sannikov (2008) and take the agent’s continuation value (continuation payoff or promised utility) as one state variable.
The absence of wealth effect under CARA preference allows me to characterize the optimal contract by an ordinary differential equation (ODE) in Subsection 2.3. I derive the (second-best) firm value and the agent’s pay-performance sensitivity (PPS, the dollar to-dollar measure as in Jensen and Murphy, 1990) based on the optimal contracting. I also characterize the condition that ensures the empirical regularity of an inverse relation between the agent’s pay-performance sensitivity and firm size.
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A model of dynamic compensation and capital structure
