Manager Characteristics and Capital Structure: Theory and Evidence

We investigate the effects of manager characteristics on capital structure. We first develop a dynamic structural model that incorporates managerial discretion in effort and financing, as well as agency conflicts between managers and outside investors. We derive the manager’s dynamic contract and implement it through financial securities. This leads to a dynamic capital structure for the firm consisting of inside equity, outside equity, long-term debt and a cash reserve (or short-term debt). We calibrate the model to aggregate data and infer the key manager-specific parameters—ability, risk aversion and disutility of effort. Our theoretical analysis generates the following novel testable predictions: • The firm’s long-term debt ratio declines with the manager’s ability and with her equity ownership in the firm. • The firm’s short-term debt ratio declines with the manager’s ability and increases with her equity ownership. • The long-term debt ratio increases with earnings risk and decreases with project risk. Our empirical analysis provides significant support for the above testable implications. Broadly, our study shows that managerial discretion and manager-specific characteristics are important determinants of firms’ financial policies.