Financial Amplification, Executive Compensation, and Optimal Capital Structure

A new mechanism is proposed demonstrating how financial frictions can amplify real shocks to the economy. Building on work by Chang (1993), I show within a simple general equilibrium model that the preferences of managers and investors are more aligned in times of high productivity. In an environment of asymmetric information, this implies low agency costs in periods of high productivity and vice versa. Moving towards a business cycle analysis, I provide preliminary quantitative results on the comovement between firm productivity and other variables. When productivity is high, debt and equity financing are both high as well. Although also leverage is increasing in firm productivity, default rates are decreasing. In this model, capital structure is part of the optimal contract between managers and investors designed in response to the information frictions present in the economy. The optimal capital structure is determined by a trade-off between the costs of outside equity (agency costs associated with free cash flow) and the costs of outside debt financing (risk of bankruptcy). Manager compensation consists of a fixed component with performance bonus and is convex in output. The separation between ownership and corporate control observed for publicly traded companies arises endogenously in equilibrium.