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Conflicts between Managers and Investors over the Optimal Financial Contract

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  • Richard Fairchild

    (Department of Corporate Finance, University of Bath, U.K.)

Abstract

We develop a principal-agent model of financial contracting in which investors face moral hazard problems relating to managerial effort. The level of debt potentially mitigates these problems in two ways. For high debt levels, the manager owns more of the equity, and also the threat of financial distress increases. In the absence of financial distress costs, we derive a novel irrelevance result; the financial contract does not affect managerial effort or firm value. Therefore, the manager and the investors are indifferent between a high debt and low debt contract. In the presence of financial distress costs, the manager has an incentive to increase his effort level in order to reduce the threat of distress. Now investors unambiguously prefer the (value-maximising) high debt contract. When effort costs and financial distress costs are low, the manager also prefers the high debt contract. When effort costs and financial distress costs are high, the manager prefers the (value-minimising) low debt contract.

Suggested Citation

  • Richard Fairchild, 2003. "Conflicts between Managers and Investors over the Optimal Financial Contract," International Journal of Business and Economics, School of Management Development, Feng Chia University, Taichung, Taiwan, vol. 2(3), pages 197-212, December.
  • Handle: RePEc:ijb:journl:v:2:y:2003:i:3:p:197-212
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    References listed on IDEAS

    as
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    5. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-329, May.
    6. Philippe Aghion & Patrick Bolton, 1992. "An Incomplete Contracts Approach to Financial Contracting," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 59(3), pages 473-494.
    7. Mathias Dewatripont & Jean Tirole, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 1027-1054.
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    Cited by:

    1. Dimitrios I. Maditinos & Alexandra V. Tsinani & Željko Šević, 2015. "Managerial optimism and the impact of cash flow sensitivity on corporate investment: The case of Greece," International Journal of Business and Economic Sciences Applied Research (IJBESAR), International Hellenic University (IHU), Kavala Campus, Greece (formerly Eastern Macedonia and Thrace Institute of Technology - EMaTTech), vol. 8(2), pages 35-54, October.
    2. Jong-Shin Wei & Chwen-Chi Liu, 2003. "Structure, Conduct, and Performance of Principal-Agent Models: An Overview," International Journal of Business and Economics, School of Management Development, Feng Chia University, Taichung, Taiwan, vol. 2(3), pages 177-178, December.

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    More about this item

    Keywords

    financial contracting; moral hazard; equity ownership; financial distress;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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