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A model of dynamic compensation and capital structure

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  • He, Zhiguo

Abstract

This paper studies the optimal compensation problem between shareholders and the agent in the Leland (1994) capital structure model, and finds that the debt-overhang effect on the endogenous managerial incentives lowers the optimal leverage. Consistent with data, our model delivers a negative relation between pay-performance sensitivity and firm size, and the interaction between debt-overhang and agency issue leads smaller firms to take less leverage relative to their larger peers. During financial distress, a firm's cash flow becomes more sensitive to underlying performance shocks due to debt-overhang. The implications on credit spreads and debt covenants are also considered.

Suggested Citation

  • He, Zhiguo, 2011. "A model of dynamic compensation and capital structure," Journal of Financial Economics, Elsevier, vol. 100(2), pages 351-366, May.
    • Handle: RePEc:eee:jfinec:v:100:y:2011:i:2:p:351-366
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