Capital Structure, Compensation and Incentives

Posted: 29 Feb 2008

See all articles by Alan V. S. Douglas

Alan V. S. Douglas

University of Waterloo - School of Accounting and Finance

Date Written: 2006

Abstract

This article illustrates an incentive-aligning role of debt in the presence of optimal compensation contracts. Owing to information asymmetry, value-maximizing compensation contracts allow managerial rents following high investment outcomes. The manager has an incentive to increase these rents by choosing investments that generate greater information asymmetry. An aptly chosen debt level mitigates this incentive, because investments that generate greater information asymmetry have more volatile outcomes. The greater volatility would make the debt risky, causing the shareholders to focus on high outcomes and therefore compensation contracts that reduce managerial rents. At the optimum, the manager avoids opportunistic investments, and the shareholders offer value-maximizing compensation contracts. Empirically, the analysis predicts a negative relationship between leverage and market-to-book that is reversed at extreme market-to-book ratios, a negative relationship between leverage and profitability, a negative relationship between leverage and pay-for-performance, and a positive relationship between pay-for-performance and investment opportunities.

Suggested Citation

Douglas, Alan V. S., Capital Structure, Compensation and Incentives ( 2006). The Review of Financial Studies, Vol. 19, Issue 2, pp. 605-632, 2006, Available at SSRN: https://ssrn.com/abstract=900715 or http://dx.doi.org/10.1093/rfs/hhj010

Alan V. S. Douglas (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

289 Hagey Hall
Waterloo, Ontario N2L 3G1
Canada
519-888-4567 Ext. 5945 (Phone)

HOME PAGE: http://www.arts.uwaterloo.ca/ACCT/people/douglas.htm

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