Debt and Managerial Rents in a Real-Options Model of the Firm

We present a theory of capital investment and debt and equity financing in a real-options model of a public corporation. The theory assumes that managers maximize the present value of their future compensation (managerial rents), subject to constraints imposed by outside shareholders' property rights to the firm's assets. Absent bankruptcy costs, managers follow an optimal debt policy that generates efficient investment and disinvestment. We show how bankruptcy costs can distort both investment and disinvestment. We also show how managers' personal wealth constraints can lead to delayed investment and increased reliance on debt financing. Changes in cash flow can cause changes in investment by tightening or loosening the wealth constraints. Firms with weaker investor protection adopt higher debt levels.

[1]  J. Baker.  Executive Compensation Payments by Large and Small Industrial Companies , 1939 .

[2]  S. Myers.  Determinants of corporate borrowing , 1977 .

[3]  M. C. Jensen,et al.  Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers , 1999 .

[4]  Steven M. Fazzari,et al.  Financing Constraints and Corporate Investment , 1987 .

[5]  Robert Heinkel,et al.  Dynamic Capital Structure Choice: Theory and Tests , 1989 .

[6]  René M. Stulz,et al.  Managerial discretion and optimal financing policies , 1990 .

[7]  John Parsons,et al.  Measuring the Agency Cost of Debt , 1992 .

[8]  Pierre Mella-Barral,et al.  Strategic Debt Service , 1997, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[9]  Suresh M. Sundaresan,et al.  Design and Valuation of Debt Contracts , 1994 .

[10]  H. Leland..  Corporate Debt Value, Bond Covenants, and Optimal Capital Structure , 1994, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[11]  Eduardo S. Schwartz,et al.  Investment Under Uncertainty. , 1994 .

[12]  Jeffrey Zwiebel,et al.  Dynamic Capital Structure Under Managerial Entrenchment , 1995 .

[13]  S. Kaplan,et al.  Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints? , 1997 .

[14]  R. Hubbard,et al.  Capital-Market Imperfections and Investment , 1997 .

[15]  H. Leland..  Agency Costs, Risk Management, and Capital Structure , 1998 .

[16]  M. Weisbach,et al.  Measuring investment distortions arising from stockholder-bondholder conflicts , 1999 .

[17]  A. Shleifer,et al.  Investor Protection and Corporate Valuation , 1999 .

[18]  Pierre Mella-Barral.  The Dynamics of Default and Debt Reorganization , 1999 .

[19]  Suresh M. Sundaresan,et al.  Debt Valuation, Renegotiation, and Optimal Dividend Policy , 2000 .

[20]  Sheridan Titman,et al.  The Debt-Equity Choice , 2001, Journal of Financial and Quantitative Analysis.

[21]  Bart M. Lambrecht,et al.  The Impact of Debt Financing on Entry and Exit in a Duopoly , 2001 .

[22]  Paul A. Gompers,et al.  CORPORATE GOVERNANCE AND EQUITY PRICES , 2002 .

[23]  Erwan Morellec,et al.  Can Managerial Discretion Explain Observed Leverage Ratios? , 2001 .

[24]  E. Morellec.  ASSET LIQUIDITY, CAPITAL STRUCTURE AND SECURED DEBT , 2001 .

[25]  Glenn Boyle,et al.  Investment, Uncertainty, and Liquidity , 2001 .

[26]  Baruch Lev,et al.  Corporate Earnings: Facts and Fiction , 2003 .

[27]  Ivo Welch.  Forthcoming : Journal of Political Economy , February 2004 Capital Structure and Stock Returns ∗ , 2003 .

[28]  G. Pawlina.  Underinvestment, Capital Structure and Strategic Debt Restructuring , 2005 .

[29]  R2 Around the World: New Theory and New Tests , 2006 .

[30]  Ilya A. Strebulaev,et al.  Do Tests of Capital Structure Theory Mean What They Say? , 2004 .

[31]  M. Flannery,et al.  Partial Adjustment Toward Target Capital Structures , 2004 .

[32]  David C. Mauer,et al.  Interactions of corporate financing and investment decisions: The effects of agency conflicts , 2005 .

[33]  Sudipto Sarkar,et al.  Real options, agency conflicts, and optimal capital structure , 2005 .

[34]  Corporate Governance, Leverage and Dividend Policy , 2005 .

[35]  S. Myers,et al.  A Theory of Takeovers and Disinvestment , 2005 .

[36]  Michael R. Roberts,et al.  Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure , 2006 .