Can Managerial Discretion Explain Observed Leverage Ratios?

Abstract

This article analyzes the impact of managerial discretion and corporate control mechanisms on leverage and firm value within a contingent claims model where the manager derives perquisites from investment. Optimal capital structure reflects both the tax advantage of debt less bankruptcy costs and the agency costs of managerial discretion. Actual capital structure reflects the trade-off made by the manager between his empire-building desires and the need to ensure sufficient efficiency to prevent control challenges. The model shows that manager-shareholder conflicts can explain the low debt levels observed in practice. It also examines the impact of these conflicts on the cross-sectional variation in capital structures.Since Modigliani and Miller (1958), economists have devoted much effort to studying the financing policies of firms. The capital structure of a firm is now regarded as being determined by a broad range of factors including taxes, bankruptcy costs, and conflicts of interests among claim holders. Yet despite the development of this literature, its applications have been limited by the fact that it only provides qualitative guidance.Contingent claims models provide a consistent framework for multiperiod valuation and hence it has been argued that they could offer a useful framework to analyze firms' financing policies.1 But when applied to capital structure decisions, these models suffer from two major limitations. First, for reasonable input parameter values, they generate leverage ratios that exceed those observed in practice. Second, these models cannot reproduce the cross-sectional variation in capital structures. One potential explanation for these limitations is that these models have overlooked some determinants of debt policyÐin particular the impact of agency conflicts on firms' financing decisions.

Does Stakeholder Management have a Dark Side?

“…Hence, debt plays an important role in controlling managerial power and discretion. Debt financing is also desirable from a shareholder perspective as it increases firm value by providing a tax shield and by reducing the free cash flow (Morellec, 2004). The disciplining and value-enhancing effects must, nonetheless, be weighed with the hidden costs of debt; among others, higher expected bankruptcy costs.…”

“…Although it might be optimal for shareholders to increase leverage in order to constrain managers' opportunities to follow personal objectives (Morellec, 2004), efficiency and financial performance could be perceived as secondary to stakeholders' needs in SM committed firms. Morellec (2004, p. 258), for instance, shows that when managers do enjoy higher discretion over firm policies, ''firms will issue less debt than optimal.''…”

Capital Structure Decisions: Which Factors are Reliably Important?

“…Trade-off theory also includes models such as Stulz (1990) and Morellec (2004) in which agency costs play a crucial role. Trade-off theory also includes models such as Stulz (1990) and Morellec (2004) in which agency costs play a crucial role.…”

Leaning Against the Wind: Debt Financing in the Face of Adversity

“…The MTNs hypothesis is related to models like Stulz (1990) that relate corporate capital structures to managerial incentives and Zwiebel (1996), Morellec (2004), and Lambrecht and Myers (2008), which also recognize the discretionary role of management and focus on the conflict of interest between managers and shareholders. There is relatively little empirical work relating managerial incentives to corporate financing decisions.…”