The Dynamics of Optimal Capital Structure and Compensation

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

This research on a theory of the optimal capital structure of the firm and the optimal compensation of the firm's managers is based on Michael Jensen's hypothesis that a firm's choice of capital structure is determined by a trade-off between agency costs and monitoring costs. The investigators model this tradeoff dynamically. The model assumes that early on in the production process, outside investors face an information friction with respect to withdrawing funds from the firm that dissipates over time. The model assumes that they also face an agency friction that increases over time with respect to funds left inside the firm. These frictions are binding for the duration of an accounting cycle over which the realization of the proceeds of the firm's productive activity is manifest. This simple structure is able to generate a rich theory of the financial structure of the firm. These frictions motivate the division of firm's payout into debt and outside equity payments, and the division of executive compensation into base pay and a performance bonus. The trade-off between the monitoring and agency costs associated with these frictions, along with the impact of shocks to productivity, lead to a theory of the dynamics of capital structure and compensation. To extend this model to a dynamic setting, the investigators assume that there is an information cycle in which outside investors first face an information friction and then face an agency friction. This cycle is repeated indefinitely. The investigators associate this cycle with an accounting or capital budgeting cycle at the firm. They show the qualitative decomposition of the optimal contract into four payments - base pay and performance pay for the manager, and debt and equity-like payments to the outside investors - holds both in a static setting in which there is only one information cycle, and in a dynamic setting in which there are an arbitrary number of information cycles. Thus, repetition of the contracting problem does not change, qualitatively, the interpretation of the efficient contract as a theory of capital structure and executive compensation. The investigators propose a number of extensions to this basic framework which will allow it to generate a surprisingly complete theory of corporate finance. The first extension is the role of financial hedges, which here turns out to be as an aid in fine-tuning the efficient contract when there is noncontingent debt. The second extension allows manager-specific productivity shocks which brings in the retention question and generates a motivation for golden parachute type payments with firing. The third extension allows for stochastic monitoring, which will not overturn the basic qualitative findings. The fourth extension allows for persistent productivity shocks. Finally, the investigators do a quantitative evaluation of a suitably calibrated version of the model. They present some interesting preliminary findings from the one-period model in which they show that the financial components of the efficient contract are much more sensitive to parameter changes than are the efficiency related variables. This finding suggests that their model will have interesting financial implications without also having implausibly large efficiency losses. Hence it may be consistent with the wide range of cross-industry differences in financial structure observed in the developed countries. Broader Impacts: The broader impact of our work is a comprehensive theory of the capital structure of the firm that can be used to address several long-standing questions in corporate finance. This theory is used to study the quantitative impact of financial frictions in macroeconomics.