Manager Characteristics and Capital Structure

The following post comes to us from Sanjai Bhagat, Professor of Finance at the University of Colorado at Boulder; Brian Bolton of the Finance Department at the University of New Hampshire; and Ajay Subramanian of the Risk Management and Insurance Department at Georgia State University.

In the paper, Manager Characteristics and Capital Structure: Theory and Evidence, forthcoming in the Journal of Financial and Quantitative Analysis, we theoretically and empirically investigate the effects of manager characteristics on capital structure. We develop a dynamic principal-agent model that incorporates taxes, bankruptcy costs, and managerial discretion in financing and effort. We derive the manager’s dynamic contract and implement it through financial securities, which leads to a dynamic capital structure for the firm.

We derive novel implications that link manager and firm characteristics to capital structure: (i) Long-term debt declines with manager ability and with her inside equity ownership. (ii) Short-term debt declines with manager ability, and increases with her equity ownership. (iii) Long-term debt declines with long-term risk, and increases with short-term risk. (iv) Short-term debt declines with short-term risk. With the exception of the relation between short-term debt and manager ownership, we show empirical support for the above implications. Our results show that manager characteristics are important determinants of firms’ financial policies.

We contribute to the literatures on corporate governance and dynamic corporate finance by showing how managerial discretion and manager-shareholder agency conflicts affect firms’ financial policies. Traditional structural models of capital structure assume that the manager behaves in the interests of shareholders. Consequently, managerial discretion and manager-specific characteristics have no effects on capital structure in these models. Our unified model integrates the perspectives of traditional tradeoff models in which capital structure reflects the interplay between the tax advantages of debt and bankruptcy costs, as well as agency models in which financial decisions are driven by manager-shareholder agency conflicts. The analysis of our structural model shows that managerial discretion is a very important determinant of firms’ financial structures and could, in particular, quantitatively explain firms’ observed leverage levels.

In this study, we consider a framework with limited commitment in which only single period contracts are enforceable. The generalization to the scenario in which long-term contracts are feasible is significantly more complex. In fact, in the current setup where the manager is risk-averse, earnings have unbounded support, the manager’s effort can take a continuum of values, and the relationship can be endogenously terminated, it is unclear whether a framework with long-term contracting is analytically or computationally tractable.

An additional major complication is that there are external frictions due to taxes and bankruptcy costs. Recent studies that allow for long-term contracting obtain tractability with simplifying assumptions such as zero taxes, universal risk-neutrality, a linear disutility of effort so that a “bang bang” solution for the manager’s effort choice problem is optimal, and the assumption that is always optimal to implement maximal effort by the manager. The analysis of a fairly general long-term contracting model with managerial risk aversion, taxes and bankruptcy costs is a major challenge for future research.

The full paper is available for download here.

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