The Use of Debt to Prevent Short-Term Managerial Exploitation

This paper emphasizes the versatility of debt by presenting a setting in which debt is used to assuage a manager. Our result is driven by the option-like feature of shareholder ownership in the presence of debt and the detrimental effect of diversification (reduced volatility) on option value. The diversification effect is introduced in our model when the shareholders use a “portfolio of managers” over the firm’s life. In contrast, retaining the existing manager is a riskier strategy. Debt makes this risky strategy desirable for the shareholders and, thus, serves to commit them to be more patient in firing decisions. Viewed broadly, the paper stresses the interaction between capital structure, information system design, and control systemsWe thank C.D. Aliprantis (Editor), Tim Baldenius, Joel Demski, Ron Dye, John Fellingham, Hans Frimor, Ronen Israel, Chandra Kanodia, Brian Mittendorf, James Peck, Doug Schroeder, Lixin Ye, workshop participants at Carnegie Mellon, Columbia University, Ohio State University, and the European Summer Symposium in Financial Markets, and two anonymous referees for helpful comments. Anil Arya gratefully acknowledges assistance from the John J. Gerlach Chair