Managerial Flexibility, Agency Costs and Optimal Capital Structure

This paper investigates the effect of managerial flexibility on the choice of capital structure for a firm and the corresponding valuation of its long term debt. We consider a general model in continuous time where the manager (who is not a shareholder) of a firm with long term debt in place may dynamically switch strategies at random times so as to maximize his expected discounted compensation. The manager may bear personal costs due to bankruptcy of the firm and the firm enjoys a tax shield on its interest payments to creditors. Under general assumptions on the nature of the strategies available to the manager, we show the existence of and derive explicit analytical characterizations for the optimal policies for the manager. We then derive the optimal policies for the firm that can hypothetically contract for managerial behavior ex ante, i.e. before debt is in place. We investigate the implications of these results for the optimal capital structure for the firm in the presence of managerial flexibility and the valuation of its long term debt. We also obtain precise quantitative characterizations of the agency costs of debt due to managerial flexibility in a very general context and show that they are very significant when compared with the tax advantages of debt thereby implying that managerial flexibility is a very important determinant of the choice of optimal capital structure for a firm. We carry out several numerical simulations with different choices of underlying parameter values to calculate the optimal leverage, agency costs , corporate debt values and bond yield spreads and study the comparative statics of these quantities with respect to the parameters characterizing the strategies available to the manager. The optimal leverage levels predicted by our model correspond very well with average leverage levels observed in the marketplace.