A Model of Dynamic Compensation and Capital Structure

40 Pages Posted: 18 Mar 2008 Last revised: 15 Jul 2010

See all articles by Zhiguo He

Zhiguo He

University of Chicago - Finance

Date Written: April 19, 2010


This paper studies the optimal compensation problem between shareholders and the agent in a general cash-flow setup, and offers a framework to quantitatively assess the impact of agency problems. Under the structural model of capital structure studied in Leland (1994), we find that the debt-overhang effect on the endogenous managerial incentives lowers the optimal leverage. Consistent with the 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.

Keywords: Continuous-time Contracting, Capital Structure, CARA (Exponential) Preference, Firm Growth, Size-Heterogeneity, Pay-Performance Sensitivity.

JEL Classification: C73, G32, J33, D82

Suggested Citation

He, Zhiguo, A Model of Dynamic Compensation and Capital Structure (April 19, 2010). AFA 2009 San Francisco Meetings Paper, Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=1107019 or http://dx.doi.org/10.2139/ssrn.1107019

Zhiguo He (Contact Author)

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://www.zhiguohe.com

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