Академический Документы
Профессиональный Документы
Культура Документы
a r t i c l e
i n f o
Article history:
Received 18 June 2008
Accepted 6 November 2008
Available online 19 November 2008
JEL classication:
D81
D92
E22
G31
J20
Keywords:
Agency conicts
Irreversible investment
Managerial compensation
Capital structure
a b s t r a c t
We explore the signicance of employee compensation and alternative (reservation) income on investment timing, endogenous default, yield spreads and capital structure. In a real-options setting, a managers incentive to under(over)invest in a project is associated to labor income he has to forego in
order to work on the project, the managers salary, his stake on the projects equity capital and his subsequent income, should he decide to terminate operations. We nd that the optimal level of coupon payments decreases with managerial salary and ownership stake while it is increasing in the managers
reservation income. Yield spreads (optimal leverage ratios) are increasing (decreasing) in the managers
salary and ownership stake, while they are decreasing (increasing) in the managers reservation income.
Exploring agency costs of debt as deviations from a value-maximizing investment policy, we document a
U-shaped relationship between agency costs of debt and the managerial compensation parameters: the
managers reservation income, salary and ownership share.
2008 Elsevier B.V. All rights reserved.
1. Introduction
Being the cornerstone of corporate nance, the question of capital-structure relevance to rm value has generated a still inconclusive debate which has long been enriched with the
operational exibility insights of the real-options paradigm. This
stream of literature has extensively discussed investment timing
and optimal capital structure as emerging out of the conicts of
interest between shareholders and creditors. In this paper, our
objective is to make a contribution to this debate by exploring
the incentives of a manager who makes the nancing and investment decisions and thus by redening agency costs of debt in a
real-options context.
The real-options account of the interaction between investment
and nancing decisions is now over thirty-years-old. Drawing on
the then recently developed option pricing theory, Merton (1974)
derived a valuation result for corporate bonds and employed this
result in constructing a proof on capital-structure irrelevance.
Brennan and Schwartz (1978) used the real-options approach to
reach a result on optimal capital structure and incorporated bankruptcy costs and default probability in their derivation of an optimal capital structure. It is fair to say that the now well-applied
real-options analytical platform on agency costs and capital structure can be largely attributed to the work of Mello and Parsosns
E-mail address: apa@fme.aegean.gr
0378-4266/$ - see front matter 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2008.11.002
(1992) who examined the case of a hypothetical mining investment with operational and nancial exibility and were the rst
to measure agency costs of debt. Mauer and Triantis (1994)
produced probably the richest operational exibility setting in
the debate on optimal capital structure and suggested that while
operational exibility signicantly affected the nancing decisions,
nancing exibility had little effect on the operational decision
making. The real-options account of the optimal capital-structure
debate was further advanced by Leland (1994) who introduced
the exibility of debt renegotiation, Leland and Toft (1996) who
explored the fundamental issue of optimal debt maturity and with
Leland (1998) who incorporated the choice of corporate risk and
provided a most comprehensive account of the agency-theoretic
agenda within the real-options framework. This platform has since
been enriched with market structure considerations (Lambrecht,
2001), nancing constraints (Boyle and Guthrie, 2003), stochastic
growth opportunities (Childs et al., 2005), incomplete markets
(Hugonnier and Morellec, 2007) and a handful of further modelling
extensions. However, despite the rich variety of models on capital
structure and agency costs, this debate has yet to fully incorporate
a classic agency problem: the ownermanager conict. Most of
these models have discussed corporate settings in which a creditor
signed a contract with an entrepreneur who was also the sole
owner, thus prompting the need to include managerial
discretion in investment decision making, within the real-options
framework.
710
Cadenillas et al. (2004) built on the option-like features of corporate securities and explored shareholdermanager conicts as
well as the effect of managerial compensation on capital structure.
In this modelling framework, managers were only rewarded with
stock and decided on corporate risk and the level of effort they
were to exert, while the choice of leverage and of the level of managerial compensation was made by the shareholders. In a corporate
setting where stock ownership is the only compensation of risk
averse managers which face costly effort, the capital-structure
choice would depend on the managers efciency, momentum as
well as company size. Grenadier and Wang (2005) revisited the
question of investment timing for an option to invest, in the context of ownermanager contracts in an all-equity rm. In their
agency-theoretic contribution to the problem of optimal investment timing, they explored the issue of asymmetric information
and costly effort. Decomposing the option to invest into a managers option and an owners option, they found that both underinvestment and overinvestment can hold in equilibrium. Mauer and
Sarkar (2005) examined the effect of the conict between shareholders and creditors on capital structure and on investment timing. Based on the tax-deductibility of interest income, they found
that the shareholders choice of investment and nancing will generate deviations from value maximization and will create agency
conicts and costs. In their model, the shareholders incentive to
overinvest imposes agency costs on yield spreads and the resulting
cost of capital determines nancing as well as investment
decisions.
Making a contribution to the ongoing debate on the interaction
between investment timing and capital structure, this paper is
motivated by empirical ndings that the ownercreditor agency
conict alone cannot explain the observed variations in deviations
from value-maximizing investment (Parrino and Weisbach, 1999)
and that managerial compensation is signicant in determining
capital structure (e.g. Smith and Watts, 1992) as well as corporate
value (e.g. Coles et al., 2001). We explore over-and-under investment with respect to the managers compensation and interactions
with corporate investors, in the framework of a levered rm.
Investment timing, real option value, optimal capital structure
and agency costs of debt are estimated for various structures of
managers compensation and reservation income. For the purposes
of our analysis on investment timing, we employ the investment
nancing setting of Mauer and Sarkar (2005), where corporate
decision makers decide on investment timing and optimal capital
structure, which is implemented at the moment when the project
starts. Section 2 lays out our real-options framework, Section 3
analyzes some analytical and numerical results and Section 4 concludes the paper, indicating directions for future research.
2. An investment setting
We explore the case of a rm that has a monopolistic, perpetual
right to implement an investment project. The projects cost is I.
The decision to invest is made by the rms manager.1 The managers compensation consists of an equity stake a on the rm and
a xed salary Cp which is collected per unit of time.2 In order for
1
In this approach, implicit is the assumption that the shareholders cannot manage
the operations of theproject themselves and this is why the manager is hired. This
assumption matters in the discussion ofthe managers deviations from equity
maximizing investment in Section 3: the shareholders are worseoff in the sense that
investment and nancing choices are not aligned with their objectives but, on
theother hand, running the project on their own is more inefcient (e.g. substantial
decline in operatingprotability).
2
One could argue here that the managers compensation is taxed. Imposing a
personal tax rate wouldnot change our conclusions on investment timing and capital
structure. Alternatively, one could thinkof Cp as the after-tax managers income from
salary.
dP r dPdt rPdz;
where r is a risk free interest rate, r is the standard deviation of annual returns on a portfolio that perfectly replicates the dynamics of
P, d is a convenience yield that can be earned by holding the production output in inventory, dt is an increment of time and dz is the
increment of a Wieners process. When the option to invest is exercised, the capital-structure choice is implemented and the investment project could be partly nanced with a debt contract, in
which case the amount of debt nancing is K and the shareholders
contribute the rest I K. This nancing arrangement can happen in
the setting of a line-of-credit contract (or a loan commitment), in
which external funds are committed up to a contractually specied amount to be available in a future point in time for the rms
needs. The amount of debt nancing K is determined in a contract
signed by the manager and the creditor. If debt nancing is provided, the rm faces a xed coupon payment R per unit of time. Project abandonment and bankruptcy are decided upon by the
manager. Should the rm go bankrupt, the creditor will take over
the rms assets, suffering bankruptcy costs b (0 < b < 1). In the
event of bankruptcy, the manager will nd employment in another
job that yields an income of RI that can be considered as a kind of
reservation income.
2.1. Solving for the unlevered asset value
After the project has started, the operational exibility that is
available to the managers discretion consists of the option to shut
down the project. In this all-equity case, well-known portfolio replication arguments can be used to show that the managers wealth
MU(P) satises
P C
Cp
1 sc A1 Pb1 A2 Pb2 for P > PUA ;
Mu P a
d r
r
where A1 and A2 are constants to be determined and P UA is the optimal abandonment level, maximizing the managers wealth. The
solution to the homogeneous part of the equation yields
s
2
rd 1
2r
2 > 1 and
2
2
r
r
s
2
1 r d
r d 1
2r
b2
2 < 0:
2
2
r2
r2
r
1 r d
b1
2
r2
P C
Cp
1 sc
lim M U P a
P!1
d r
r
MU PUA RI and
@MU
0
@P U
PPA
4:1
4:2
4:3
711
P CR
ML P a
1 sc
d
r
P C
M U P a 1 sc
d r
"
#
!
!b2
Cp
P UA C
Cp
P
1 sc RI
;
a
r
r
d
r
PUA
!
!b 2
!
Cp
PLD C R
Cp
P
1 sc RI
a
r
r
d
r
PLD
where
and
PLD
Cp
r
db a Cr 1 sc RI
PUA 2
:
a1 sc 1 b2
C
db2 a CR
1 sc rp RI
r
6
subject to the boundary conditions
7:1
and
14:1
EL PLD 0:
14:2
E P
7:2
V P
the abandonment trigger PUA being known from the solution to the
managerial wealth problem. These differences in the operating
choices of corporate decision makers and residual claimants seen
here in the case of default and investment triggers create the need
for an effective system of corporate control (Fama and Jensen,
1983).
This valuation result will be needed to calculate the asset value
accruing to the creditor in the event of default.
2.2. Calculating managerial wealth in a levered rm
In the case of a levered rm, the value of managers wealth
ML(P) satises
P CR
Cp
1 sc A3 Pb1 A4 Pb2 for P > P LD ;
M L P a
d
r
r
10
where A3 and A4 are constants to be determined and PLD is the optimal default trigger, as seen from the managers point of view.
Since the abandonment option is decreasing in P, we need
A3 = 0. The equation for the value of managerial wealth in the case
of the unlevered rm is subject to the following boundary
conditions.
M L PLD RI and
@M L
0
@P L
PP D
!
!b 2
P CR
PLD C R
P
1 sc
1 sc :
d
r
r
d
P LD
15
PLD
!
!b 2
P C
PUA C
P
1 sc
1 sc
d r
r
d
PUA
P CR
Cp
lim ML P a
1 sc
P!1
d
r
r
13
P CR
Cp
lim EL P a
1 sc
and
P!1
d
r
r
V U PUA 0:
a1 sc 1 b2
As for the shareholder, the value of equity EL(P) satises the following partial differential equation
As for the shareholders, the value of the unlevered rm VU(P) satises the following partial differential equation
P C
1 sc
lim V U P
P!1
d r
12
DP
R
A5 Pb1 A6 Pb2
r
16
R
and
r
L
DPD 1 bV U PLD :
lim DP
17:1
P!1
17:2
!b 2
R
R
P
U
L
DP 1 bV PD
:
r
r PLD
18
sc R @
V P V P
1
L
P
PLD
!b 2 1
A bV U PL
D
P
PLD
!b 2
:
19
11:1
11:2
11:3
3
The effect of the tax advantages of debt and of the bankruptcy costs on the choice
of capital structurehas recently been conrmed in a survey on the decision-making
criteria of European CFOs (Brounen et al., 2006) as well as in empirical work on
international evidence on the capital structure choice (de Jong et al., 2008; Wu and
Yue, 2009).
712
The manager has the right to choose the time of project implementation. Upon exercise of this real option, the manager will start
receiving salary Cp, he will pay a fraction a of the equitys contribution to investment cost (since he is rewarded with this portion of
the rms equity) but he will also have to part with his previous income PI, which could be taken to be the present value of a perpetual stream of salary payments that come from competing
professional engagements, even within the same rm.
Let PM be the exercise trigger for the investment option and K
the amount of debt nancing. The value of the managers exibility
M before the option is exercised satises
1 2 2
r P MPP r drPMP rM 0;
2
P < PM :
20
P < PM ;
MP A7 Pb1 A8 Pb2 ;
25
FPF TV L PF I PI
26
and
@F
@V L
@PPPF
@P
27
PPF
ACM
P < PF ;
FPF F M PM
FP F
28
MPM M L PM aI K PI
ACE
21
22:1
and
@M
@M L
@P PPM
@P
22:2
PP M
TVLTV D 1 aE M :
23
1 2 2
r P F PP r drPF P rF 0;
2
P < PF :
24
FPF F E PE
FPF
29
where FE is the value of the option to invest in the setting of an equity-maximizing investment policy.
Numerical results in the following discussion on investment
timing can help discuss investment timing and capital structure
as outcomes of the decision makers employment conditions: high
salary, low salary and large ownership stake.
3. Numerical results
In this section we discuss the effect of the managers reservation
income, salary and ownership stake on investment timing, optimal
capital structure, yield spreads and agency costs of debt. Numerical
results on the effect of the other parameters interest rate, bankruptcy costs, volatility, etc. can be found in previous work on real
options and capital structure (e.g. Leland, 1998; Mauer and Ott,
2000). Without any loss of generality, we will assume that RI PI,
that is the income the manager will have to forego, should he decide
to implement the project, is the same as his reservation income.
Throughout the numerical analysis of this section we employ
the same reference set of parameters: P = $1, R = $0.8, C = $0.75,
RI = $1, Cp = $0.04, I = $3, r = 0.05, d = 0.02, a = 0.03, b = 0.35,
sc = 0.2, r = 0.3.
3.1. Investment timing and capital structure: The effect of managerial
compensation
We explore the effect of the parameters which are related to the
managers compensation (reservation income, salary and ownership share) on investment timing and capital structure. It is the extent of deviation from value-maximizing investment which affects
the size of the yield spread imposed by the creditor and it is this
cost of debt that affects the managers choice over coupon size
and capital structure.
3.1.1. Managerial compensation and the interaction between
investment and nancing decisions: Managers reservation income
The managers reservation income affects the managers investment and nancing decisions and therefore affects the value of the
real option to invest and the magnitude of the yield spread on
713
Option value to the manager vs coupon payment for varying reservation income
0.85
RI=1.1
0.75
Investment trigger
RI=1
0.8
RI=1.2
0.7
0.65
0.6
FB
1. 5
EB
0.55
0. 5
0. 6
0. 7
0. 8
0. 9
1. 1
1. 2
1. 3
Reservation income
0
0.5
1.5
2.5
Coupon
Fig. 1a. Sensitivity of option value to coupon payments, for varying levels of the
managers reservation income. Output price (P) is $1, operating cost (C) is $0.75,
managers salary (Cp) is $0.04, project cost (I) is $3, risk free rate of interest (r) is
0.05, dividend yield (d) is 0.02, managers ownership share (a) is 0.03, bankruptcy
costs are 0.35 (b), tax rate for corporate income (sc) is 0.2, and standard deviation of
annual returns (r) is 0.3.
Fig. 1b. Sensitivity of investment trigger to the managers reservation income. The
investment trigger is chosen so as to maximize the value of the managers option to
invest (MB). The dashed line is the rst-best investment trigger (FB) which
maximizes value for all parties (shareholder, creditor and manager) and the dotted
line is the investment trigger in an operating policy which maximizes equity value
(EB). Output price (P) is $1, coupon payment (R) is $0.8, operating cost (C) is $0.75,
managers salary (Cp) is $0.04, project cost (I) is 3$, risk free rate of interest (r) is
0.05, dividend yield (d) is 0.02, managers ownership share (a) is 0.03, bankruptcy
costs (b) are 0.35, tax rate for corporate income (sc) is 0.2 and standard deviation of
annual returns (r) is 0.3.
Yield spread
0.5
MB
2. 5
120
110
100
90
80
70
0.8
0.9
1.1
1.2
1.3
Reservation income
Fig. 1c. Sensitivity of the yield spread to the managers reservation income. Yield
spread is dened as the difference between the effective rate on corporate debt and
the risk free rate (r). The effective rate is calculated as the ratio of coupon R to debt
value D(P). The spread is measured in basis points. Output price (P) is $1, coupon
payment (R) is $0.8, operating cost (C) is $0.75, managers salary (Cp) is $0.04,
project cost (I) is $3, risk free rate of interest (r) is 0.05, dividend yield (d) is 0.02,
managers ownership share (a) is 0.03, bankruptcy costs (b) are 0.35, tax rate for
corporate income (sc) is 0.2 and the standard deviation of annual returns (r) is 0.3.
crease the level of the optimal coupon payment as well as the optimal leverage ratio5, since debt is cheaper and also because increased
tax shields are required to induce the manager to give up his reservation income and start the project. As far as I know, there has been
no previous research to associate the managers income from alternative employment opportunities with the capital-structure question in a dynamic setting of irreversible investment.
5
We dene the optimal leverage ratio as the prevailing leverage ratio when the
coupon payment is at its optimal level.
714
In the case of our numerical example (Fig. 1b), the optimal size
of the coupon ranges from $1.02 for the RI = $1 case to $1.29 for the
RI = $1.2 case. However, due to the fact that optimal coupon payment increases with the reservation income, the decline in option
value starts at lower coupon levels in the case of low reservation
incomes and this is the reason that after the optimal coupon payment has been reached and before option exercise option value
for low reservation income can briey be less than option value
for options with higher reservation income. For our parameter
set, option should be immediately exercised for coupon values on
the right of the kink in the coupon-option graph. After the option
to invest has been exercised, we are essentially addressing an issue
of the effect of coupon payments on managers wealth when he is
in charge of an ongoing project and the negative association between reservation income and the value of the managerial option
still holds for the reasons discussed above.
In the setting of our numerical example, we observe that, as we
expected, optimal leverage is increasing in the managers reservation income; optimal leverage ratio is 0.43 for R = $1 and it increases to 0.52 for R = $1.2. It is the lower yield spreads for high
levels of reservation income that make increased leverage more
attractive in the case of higher reservation income.
3.1.2. Managerial compensation and the interaction between
investment and nancing decisions: Managers salary
Having examined the impact of the managers reservation income on investment timing and the capital-structure choice, we
proceed to explore the effect of the managers compensation contract that consists of salary and a share of equity ownership. Our
numerical examination of the effect of the managers salary on
the interaction between investment and nancing decisions has
yielded the following result.
Result 2: The managers salary has a negative effect on the level
of the investment trigger and it has a positive effect on the value of
the managers real option to invest as well as on the level of the
yield spread.
High levels of salary naturally make the managers option worth
more and also increase managerial wealth in the case of managing
an ongoing levered company after the project has started (Fig. 2a).
Furthermore, the higher the managers salary, the stronger the
managers motive to start the project and hence to exercise the real
option at a lower level of P (Fig. 2b). For low salary levels, the
manager does not want to give up his reservation income and
get involved in the project, thus leading to phenomena of underinvestment with respect to both FB and EB policies.
Associated with the managers motive to overinvest, the effect
of the managers salary on the yield spreads is positive. An increased salary will strengthen the managers incentive to overinvest so as to start getting paid and will also make him want to
(suboptimally) keep the project alive for as long as possible, so as
to maintain the xed income ow. This overinvestment motive
leads to high spreads in the cases of high salaries (Fig. 2c). Higher
costs of debt for higher levels of salary mean that, as the managers
salary increases, the optimal coupon size and the optimal leverage
ratio decrease; optimal coupon size is $1.29 and optimal leverage
is 0.52 for a salary of $0.03, while optimal coupon size is $0.75
and optimal leverage is 0.27 for a salary of $0.05).
Our result on the effect of managers salary on investment timing and capital structure extends the discussion in Mauer and Sarkar (2005) on the determinants of investment and nancing
decisions in a real-options framework.
3.1.3. Managerial compensation and the interaction between
investment and nancing decisions: Managers ownership stake
Managerial ownership has often been employed as a contractual mechanism in the direction of aligning the objectives of the
managers with the ones of the owners. The following result summarizes the ndings of our analysis on effect of managerial ownership on the managers choice over investment timing and capital
structure.
Result 3: The managers ownership share has a negative effect
on the level of the investment trigger and it has a positive effect
on the value of the managers real option to invest as well as on
the level of the yield spread.
The effect of the managers ownership share on the value of his
option to start a project is, of course, positive (Fig. 3a). The higher
the compensation involved in running the project, the more valuable will the option be and the more valuable his wealth will be
Option value to the manager vs coupon payment for varying manager's salary
Cp =0 .0 5
0. 85
Investment trigger
0. 9
0. 8
0. 75
2.5
FB
1.5
EB
Cp =0 .0 4
0. 7
1
0. 65
Cp =0 .0 3
0. 6
0.5
0.02
0. 5
0.025
0.03
0.035
0.04
0.045
0.05
0.055
0.06
Manager's salary
0. 55
0. 5
1. 5
2. 5
Coupon
Fig. 2a. Sensitivity of option value to coupon payments, for varying managers
salary. Output price (P) is $1, operating cost (C) is $0.75, managers reservation
income (RI) is $1, project cost (I) is $3, risk free rate of interest (r) is 0.05, dividend
yield (d) is 0.02, managers ownership share (a) is 0.03, bankruptcy costs are 0.35
(b), tax rate for corporate income (sc) is 0.2 and standard deviation of annual returns
(r) is 0.3.
Fig. 2b. Sensitivity of investment trigger to the managers salary. The investment
trigger is chosen so as to maximize the value of the managers option to invest (MB).
The dashed line is the rst-best investment trigger (FB) which maximizes value for
all parties (shareholder, creditor and manager) and the dotted line is the investment
trigger in an operating policy which maximizes equity value (EB). Output price (P) is
$1, coupon payment (R) is $0.8, operating cost (C) is $0.75, managers reservation
income (RI) is $1, project cost (I) is 3$, risk free rate of interest (r) is 0.05, dividend
yield (d) is 0.02, managers ownership share (a) is 0.03, bankruptcy costs (b) are
0.35, tax rate for corporate income (sc) is 0.2 and standard deviation of annual
returns (r) is 0.3.
715
Yield spread
130
120
110
100
90
80
70
0. 02
0. 025
0. 03
0. 035
0. 04
0. 045
0. 05
Manager's salary
Fig. 2c. Sensitivity of the yield spread to the managers salary. Yield spread is
dened as the difference between the effective rate on corporate debt and the risk
free rate (r). The effective rate is calculated as the ratio of coupon R to debt value
D(P). The spread is measured in basis points. Output price (P) is $1, coupon payment
(R) is $0.8, operating cost (C) is $0.75, managers reservation income (RI) is $1,
project cost (I) is $3, risk free rate of interest (r) is 0.05, dividend yield (d) is 0.02,
managers ownership share (a) is 0.03, bankruptcy costs (b) are 0.35, tax rate for
corporate income (sc) is 0.2 and the standard deviation of annual returns (r) is 0.3.
after the exercise of the investment option (on the right of the
kink).
The level of the investment exercise trigger is decreasing in the
level of the managers ownership share; for low levels of managerial ownership share, the manager is less eager to leave his previous (reservation) income in order to start the project and gain a
small portion of corporate prots and tax shields and therefore
he tends to underinvest, compared to both the rst-best investment trigger and the equity-maximizing investment policy. For
sufciently high levels of ownership share, he is more willing to
part with his reservation income and benet from the tax shields
of debt and this is why he will end up overinvesting (Fig. 3b).
Our nding that managerial ownership can be associated with
deviations from equity-maximizing and also from value-maximizing investment is in line with the intuition of John and John (1993)
that managerial ownership affects the agency costs of both equity
and debt. It is interesting that, for high levels of a, additional ownership does not offer improved alignment with equity-maximizing
investment policies. This is a result of the fact that for high levels of
managerial ownership, the sensitivity of the investment trigger to
the managers salary and reservation income weakens and the
deviations from equity-maximization cannot be further restrained
by granting the managers an additional stake of corporate ownership. The weak sensitivity of the investment trigger with respect to
managerial ownership agrees with empirical evidence in Singh and
Davidson (2003) that increased managerial ownership cannot
eliminate managerial motives to exercise discretion and deviate
from equity maximization.
Fig. 3c shows that the higher the managers stake on equity
ownership, the higher the yield spread will be. This is because
the higher the managers equity stake, the stronger the tendency
of the manager to abide by an equity-maximizing policy calling
for overinvestment and late default in order to rip off the tax
shields of debt. Therefore, in the case of increased managerial ownership, the increased risk of debt contracts can lead to an increased
yield spread. This result is in accordance with the theoretical prediction of John and John (1993) as well as the empirical evidence of
Strock Bagnani et al. (1994) and Dadyvenko and Strebulaev (2007)
that yield spreads should be increasing in the ownership component of managerial compensation.
The positive effect of managerial ownership on yield spreads
and hence on the cost of debt means that higher levels of managerial ownership will be associated with lower levels of optimal coupon payment and also with lower optimal leverage ratios; as the
managers ownership stake increases, the size of the optimal coupon decreases from $1.02 for a = 0.03 to $0.87 for a = 0.07. For this
parameter range, the optimal leverage ratio falls from 0.43 to 0.27
because the equity-driven incentive to overinvest leads to increased yield spreads and therefore to a lower optimal coupon
2.4
Option value to the manager vs coupon payment for varying ownership shares
2
2.2
Investment trigger
a=0.7
1.8
1.6
1.4
a=0.5
MB
1.8
FB
1.6
1.2
1.4
EB
1
0
0.8
a=0.3
0.5
1.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
2.5
Coupon
Fig. 3a. Sensitivity of option value to coupon payments, for varying managers
ownership share. Output price (P) is $1, operating cost (C) is $0.75, managers salary
(Cp) is $0.04, managers reservation income (RI) is $1, project cost (I) is $3, risk free
rate of interest (r) is 0.05, dividend yield (d) is 0.02, bankruptcy costs are 0.35 (b),
tax rate for corporate income (sc) is 0.2 and standard deviation of annual returns (r)
is 0.3.
Fig. 3b. Sensitivity of investment trigger to the managers ownership share. The
investment trigger is chosen so as to maximize the value of the managers option to
invest (MB). The dashed line is the rst-best investment trigger (FB) which
maximizes value for all parties (shareholder, creditor and manager) and the dotted
line is the investment trigger in an operating policy which maximizes equity value
(EB). Output price (P) is $1, coupon payment (R) is $0.8, operating cost (C) is $0.75,
managers reservation income (RI) is $1, managers salary (Cp) is $0.04, project cost
(I) is 3$, risk free rate of interest (r) is 0.05, dividend yield (d) is 0.02, bankruptcy
costs (b) are 0.35, tax rate for corporate income (sc) is 0.2 and standard deviation of
annual returns (r) is 0.3.
716
155
0. 04
150
0.035
0. 03
Yield spread
145
140
135
130
0. 02
0.015
AC E
0. 01
125
120
0. 05
AC M
0.025
0.005
0. 1
0. 15
0. 2
0. 25
0. 3
0. 35
0. 4
0. 45
0
0. 7
0. 5
0. 8
0. 9
and leverage ratio. This result is in accordance with ndings in Jensen et al. (1992) that higher insider ownership is associated with
lower levels of debt.
3.2. The effect of managerial compensation on agency costs of debt
Agency costs of debt were dened in (28) as the percentage difference of option value under an investment policy that maximizes
total value (i.e. equity, debt, managerial wealth) and option value
under an investment policy that aims at maximizing managerial
wealth. Our numerical solutions on the effect of managerial compensation on agency costs have produced the following nding.
Result 4: There is an U-shaped relationship between agency
costs of debt and the managerial compensation parameters: the
managers reservation income, salary and ownership share.
We see in Fig. 4a that there exists an U-shaped pattern with respect to the effect of the managers reservation income to the
agency costs of debt. For very low values of reservation income
there is a strong incentive to overinvest and this leads to deviations
from value maximization. As the reservation income increases,
overinvestment incentives weaken and agency costs of debt decrease. However, beyond a point, high values of reservation income
decrease the attractiveness of project-related compensation to the
manager and thus he tends to underinvest and underinvestment
leads to increased agency costs of debt. The ACE line in Fig. 4a
shows agency costs of debt under an equity-maximizing setting,
as dened in (28). We see that the agency costs of debt are lower
under the equity-maximizing investment and nancing policies,
in cases reservation income is too low (worse managerial overinvestment) or too high (worse managerial underinvestment). For
intermediate values of reservation income, we see that the agency
costs of debt under an equity-maximizing policy are higher than
under a policy that maximizes managerial wealth. This means that
the creation of an agency conict generates an outcome that is closer to the rst-best value maximization under the managers than
under the shareholders wealth maximization. This result can be
considered as an extension of the intuition of Brander and Poitevin
(1992) and John and John (1993), in the direction of dynamic
investment choice.
1. 1
1. 2
1. 3
1. 4
Fig. 4a. Sensitivity of agency costs of debt to the managers reservation income.
Agency costs of debt (ACM) are dened as the percentage difference between option
value under a nancinginvestment policy that maximizes managerial wealth and
one that maximizes value for all parties (shareholder, creditor and the manager).
The ACE line plots agency costs of debt in an equity-maximizing investment
nancing policy. Output price (P) is $1, coupon payment (R) is $0.8, operating cost
(C) is $0.75, managers salary (Cp) is $0.05, project cost (I) is $3, risk free rate of
interest is (r) 0.05, dividend yield (d) is 0.02, managers ownership share (a) is 0.03,
bankruptcy costs (b) are 0.35, tax rate for corporate income (sc) is 0.2 and standard
deviation of annual returns (r) is 0.3.
Fig. 3c. Sensitivity of the yield spread to the managers ownership share. Yield
spread is dened as the difference between the effective rate on corporate debt and
the risk free rate (r). The effective rate is calculated as the ratio of coupon R to debt
value D(P). The spread is measured in basis points. Output price (P) is $1, coupon
payment (R) is $0.8, operating cost (C) is $0.75, managers reservation income (RI) is
$1, managers salary (Cp) is $0.04, project cost (I) is $3, risk free rate of interest (r) is
0.05, dividend yield (d) is 0.02, bankruptcy costs (b) are 0.35, tax rate for corporate
income (sc) is 0.2 and the standard deviation of annual returns (r) is 0.3.
Reservation income
ACM
0.025
0.02
0.015
ACE
0.01
0.005
0
0.02
0.025
0.03
0.035
0.04
0.045
0.05
0.055
Manager's salary
Fig. 4b. Sensitivity of agency costs of debt to the managers salary. Agency costs of
debt (ACM) are dened as the percentage difference between option value under a
nancinginvestment policy that maximizes managerial wealth and one that
maximizes value for all parties (shareholder, creditor and the manager). The ACE
line plots agency costs of debt in an equity-maximizing investmentnancing
policy. Output price (P) is $1, coupon payment (R) is $0.8, operating cost (C) is $0.75,
managers reservation income (RI) is $1, project cost (I) is $3, risk free rate of
interest is (r) 0.05, dividend yield (d) is 0.02, managers ownership share (a) is 0.03,
bankruptcy costs (b) are 0.35, tax rate for corporate income (sc) is 0.2 and standard
deviation of annual returns (r) is 0.3.
717
effects weaken and the managers policy approaches value-maximization choices. Beyond a certain point of salary increase however, the manager will have an incentive to invest too early so as
to earn the high salary and will also have the incentive to default
too late so as not to give up the substantial salary income. These
managerial incentives cause the agency costs of debt to increase
in the case of high salary compensations. Between these two extreme cases, agency costs of debt in an equity-maximizing regime
are higher, compared to agency costs of debt under a policy that
maximizes managerial wealth.
Agency costs of debt have a U-shaped relationship with the
managers ownership stake. For low levels of managerial ownership, the manager will underinvest since compensation from the
project may be less attractive compared to the reservation income.
This underinvestment motive weakens as the managers ownership stake increases, shortening the deviations from a value-maximizing investment policy. However, beyond a point, increased
ownership renders the project increasingly attractive, leading to
overinvestment and an increase in deviations from value-maximizing policies. We observe in Fig. 4c that agency costs of debt under a
policy that maximizes managerial wealth (ACM) are lower than
agency costs of debt in a setting of equity maximization (ACE). This
is because the overinvestment incentives of the shareholders are
partly offset by the effects of the managers reservation income.
This effect of managerial ownership on the agency costs of debt
is more prevalent when managerial ownership is at low levels.
When the managers stake on equity capital is large, we have seen,
in Section 3.1, that the marginal effect of managerial ownership on
the decisions to invest and default is rather small. As a result of
this, when managerial ownership is large, the agency costs of debt
will not be substantially affected by the extent of managerial
ownership.
Deviations from value maximization are a result of the debt and
employment contracts. Given that the employment contract determines managerial wealth taking into account both salary and stock
ownership for a given reservation income there is a plethora of
contracts that will provide the manager with the same level of ex-
0.015
0.08
ACE
0.07
Manager's salary
RI=1
RI=1.1
0.06
0.01
0.005
ACM
0.05
0.04
0.03
0.02
0
0.02
0.01
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
0.2
0
0.03
0.035
0.04
0.045
0.05
0.055
718
Investment trigger
3.5
3
2.5
References
2
1.5
1
0.5
0
0.08
0.06
0.055
0.05
0.04
0.045
0.04
0.02
Manager's salary
0.035
0
0.03
Manager'sownership share
Boyle, G.W., Guthrie, G.A., 2003. Investment, uncertainty and liquidity. Journal of
Finance 58, 21432166.
Brander, J.A., Poitevin, M., 1992. Managerial compensation and the agency costs of
debt nance. Managerial and Decision Economics 13, 5564.
Brennan, M.J., Schwartz, E.S., 1978. Corporate income taxes, valuation and the
problem of optimal capital structure. Journal of Business 51, 103114.
Brounen, D., de Jong, S., Koedijk, L., 2006. Capital structure policies in Europe:
Survey evidence. Journal of Banking and Finance 30, 14091442.
Cadenillas, A., Cvitanic, J., Zapatero, F., 2004. Leverage decision and manager
compensation with choice of effort and volatility. Journal of Financial
Economics 73, 7192.
Childs, P.D., Mauer, D.C., Ott, S.H., 2005. Interactions of corporate nancing and
investment decisions: The effect of agency conicts. Journal of Financial
Economics 76, 667690.
Coles, J.W., McWilliams, V.B., Sen, N., 2001. An examination of the relationship of
governance mechanisms to performance. Journal of Management 27, 2350.
Dadyvenko, S.A., Strebulaev, I.A., 2007. Strategic actions and credit spreads. Journal
of Finance 62, 26332671.
de Jong, A., Kabir, R., Nguyen, T.T., 2008. Capital structure around the world: The
roles of rm- and country-specic determinants. Journal of Banking and
Finance 32, 19541969.
Douglas, A.V.S., 2001. Managerial replacement and corporate nancial policy with
endogenous manager-specic value. Journal of Corporate Finance 7, 2552.
Fama, E.F., Jensen, M.C., 1983. Separation of ownership and control. Journal of Law
Economics 26, 301326.
Grenadier, S.R., Wang, N., 2005. Investment timing, agency and information. Journal
of Financial Economics 75, 493533.
Hugonnier, J., Morellec, E., 2007. Corporate control and real investment in
incomplete markets. Journal of Economic Dynamics and Control 31, 17811800.
Jensen, G.R., Solberg, D.P., Zorn, T.S., 1992. Simultaneous determinants of insider
ownership, debt and dividend policies. Journal of Financial and Quantitative
Analysis 27, 247263.
John, T.A., John, K., 1993. Top-management compensation and capital structure.
Journal of Finance 48, 949974.
Lambrecht, B.M., 2001. The impact of debt nancing on entry and exit in a duopoly.
Review of Financial Studies 14, 765804.
Leland, H.E., 1994. Corporate debt value, bond covenants and optimal capital
structure. Journal of Finance 49, 12131252.
Leland, H.E., 1998. Agency costs, risk management and capital structure. Journal of
Finance 53, 12131243.
Leland, H.E., Toft, K.B., 1996. Optimal capital structure, endogenous bankruptcy and
the term structure of yield spreads. Journal of Finance 51, 9871019.
Mauer, D.C., Ott, S.H., 2000. Agency costs, underinvestment and optimal capital
structure: The effect of growth options to expand. In: Brennan, M.J., Trigeorgis,
L. (Eds.), Project Flexibility, Agency and Competition. Oxford University Press,
New York, pp. 151180.
Mauer, D.C., Sarkar, S., 2005. Real options, agency conicts and optimal capital
structure. Journal of Banking Finance 29, 14051428.
Mauer, D.C., Triantis, A.J., 1994. Interactions of corporate nancing and investment
decisions: A dynamic framework. Journal of Finance 49, 12531277.
Mello, A.S., Parsosns, J.E., 1992. Measuring the agency cost of debt. Journal of
Financial Economics 47, 18871904.
Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest
rates. Journal of Finance 29, 449470.
Palmon, O., Bar-Yossef, S., Chen, R-R., Venezia, I., 2008. Optimal strike prices of stock
options for effort-averse executives. Journal of Banking and Finance 32, 229
239.
Parrino, R., Weisbach, M.S., 1999. Measuring investment distortions arising from
stockholderbondholder conicts. Journal of Financial Economics 53, 342.
Singh, M., Davidson, W.N., 2003. Agency costs, ownership structure and corporate
governance mechanisms. Journal of Banking and Finance 27, 793816.
Smith, C.W., Watts, R.L., 1992. The investment opportunity set and corporate
nancing, dividend and compensation policies. Journal of Financial Economics
32, 263292.
Strock Bagnani, E., Milonas, N.T., Saunders, A., Travlos, N.G., 1994. Managers, owners
and the pricing of risky debt: An empirical analysis. Journal of Finance 49, 453
477.
Wu, L., Yue, H., (2009). Corporate tax, capital structure, and the accessibility of bank
loans: Evidence from China. Journal of Banking and Finance 33, 3038.