Agency Problems, Firm Valuation, and Capital Structure

This paper studies the optimal contracting problem in a general cashow setup, and offers a framework to quantitatively assess the impact of agency problems. A closed form solution is obtained in the square-root mean-reverting cash ow process. In the geometric Brownian cashow setup, we embed the agency problem into Leland (1994), and nd that the debt-overhang problem lowers the optimal leverage. Consistent with the data, our model delivers a negative relation between payperformance sensitivity and rm size, and the interaction between debt-overhang and agency issue leads smaller rms to take less leverage relative to their larger peers. During nancial distress, a rm's cashow becomes more sensitive to underlying performance shocks.