The following post comes to us from Erwan Morellec, Professor Finance at Ecole Polytechnique Fédérale de Lausanne; Boris Nikolov of the Department of Finance at the University of Rochester; and Norman Schürhoff, Professor of Finance at the University of Lausanne.
In our paper, Corporate Governance and Capital Structure Dynamics, forthcoming in the Journal of Finance, we examine the importance of manager-shareholder conflicts in capital structure choice and characterize their effects on the dynamics and cross section of corporate capital structure. To this end, we develop a dynamic tradeoff model that emphasizes the role of agency conflicts in firms’ financing decisions. The model features corporate and personal taxes, refinancing and liquidation costs, and costly renegotiation of debt in distress. In the model, each firm is run by a manager who sets the firm’s financing, restructuring, and default policies. Managers act in their own interests and can capture part of free cash flow to equity as private benefits within the limits imposed by shareholder protection. Debt constrains the manager by reducing the free cash flow and potential cash diversion (as in Jensen, 1986, Zwiebel, 1996, or Morellec, 2004). In this environment, we determine the optimal leveraging decision of managers and characterize the effects of manager-shareholder conflicts on target leverage and the pace and size of capital structure changes.