Capital Structure, Compensation and Incentives

This article illustrates an incentive-aligning role of debtin the presence of optimal compensation contracts. Owing toinformation asymmetry, value-maximizing compensation contractsallow managerial rents following high investment outcomes. Themanager has an incentive to increase these rents by choosinginvestments that generate greater information asymmetry. Anaptly chosen debt level mitigates this incentive, because investmentsthat generate greater information asymmetry have more volatileoutcomes. The greater volatility would make the debt risky,causing the shareholders to focus on high outcomes and thereforecompensation contracts that reduce managerial rents. At theoptimum, the manager avoids opportunistic investments, and theshareholders offer value-maximizing compensation contracts.Empirically, the analysis predicts a negative relationship betweenleverage and market-to-book that is reversed at extreme market-to-bookratios, a negative relationship between leverage and profitability,a negative relationship between leverage and pay-for-performance,and a positive relationship between pay-for-performance andinvestment opportunities.