Manager Characteristics and Capital Structure: Theory and Evidence∗

We theoretically and empirically investigate the effects of manager-specific characteristics on capital structure. We develop a dynamic structural model in which a manager affects a firm’s earnings through her ability and effort. The manager receives dynamic incentives through explicit contracts with shareholders. We derive the manager’s contracts and implement them through financial securities. The firm’s resulting capital structure is dynamic, and consists of long-term debt, short-term debt, inside equity, and outside equity. The different components of the firm’s capital structure reflect the interactive effects of taxes, bankruptcy costs, as well as agency conflicts between the undiversified manager and well-diversified outside investors. The analysis of the model generates the following novel testable predictions: (i) Long-term debt declines with the manager’s ability and with her inside equity ownership in the firm. (ii) Short-term debt declines with the manager’s ability and increases with her equity ownership. (iii) Long-term debt increases with earnings risk and decreases with project risk. We show significant support for the above testable implications in our empirical analysis. Our theoretical and empirical results show that managerial discretion and manager-specific characteristics are important determinants of firms’ financial policies. ∗We thank seminar audiences at the 2009 Allied Social Sciences Association (ASSA) Meetings (San Francisco, CA), 2008 Western Finance Association (WFA) Meetings (Waikoloa, HI), the 2008 Financial Intermediation Research Society (FIRS) Meetings (Anchorage, AK), the 2008 Financial Management Association (Europe) (FMA) Meetings (Prague, Czech Republic), Georgia State University, the University of New Hampshire, and, especially, Alex Edmans, Dirk Hackbarth, Kose John, Aydin Ozkan, and Gustav Sigurdsson for valuable comments. The usual disclaimers apply.