A model of dynamic compensation and capital structure |
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Authors: | Zhiguo He |
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Institution: | University of Chicago, Booth School of Business, United States |
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Abstract: | This paper studies the optimal compensation problem between shareholders and the agent in the Leland (1994) capital structure model, and finds that the debt-overhang effect on the endogenous managerial incentives lowers the optimal leverage. Consistent with data, our model delivers a negative relation between pay-performance sensitivity and firm size, and the interaction between debt-overhang and agency issue leads smaller firms to take less leverage relative to their larger peers. During financial distress, a firm's cash flow becomes more sensitive to underlying performance shocks due to debt-overhang. The implications on credit spreads and debt covenants are also considered. |
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Keywords: | Continuous-time contracting Capital structure CARA (exponential) preference Firm growth Size-heterogeneity Pay-performance sensitivity |
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