Dynamic Capital Structure Under Managerial Entrenchment

Abstract

This paper develops a model in which debt serves to constrain inefficient investments of empire-building managers due to the consequent control implications of bankruptcy. Capital structure is voluntarily chosen by management, as a credible constraint which ensures sufficient efficiency to prevent takeover challenges. In particular, dynamic capital structure is derived as the optimal response of partially entrenched managers trading off empire-building ambitions with the need to retain the empire to realize these ambitions. Such capital structure is dynamically consistent; in the model, manages are free to readjust leverage each period. A policy of dividend payments coordinated with capital structure decisions follows naturally, as does implicatons for the level, frequency, and maturity structure of debt as a function of outside investment opportunities. Additionally, the model yields new testable implications for security design and changes in debt and empire building over a manager's career.

JEL Classification: G32