Managerial Compensation and Capital Structure under Asymmetric Information

We consider firm financing when the firm quality is private information of the manager and, given its inherent quality, the project viability depends on the manager exerting unobservable effort. We show that capital structure matters even though managerial contracts are optimally designed. Good firms would like to issue more debt to avoid selling underpricing equity. However, the interaction between managerial compensation and leverage does not allow them to do so. Because debt is senior to (the performancerelated part of) managerial compensation, a high leverage prevents the implementation of the optimal managerial contract and so it destroys effort incentives. Therefore, we provide an explanation of why good firms appear to use debt conservatively and issue both debt and underpriced equity (even if the bankruptcy and agency costs of debt are zero). We also show that the optimal financial contract can be implemented by a combination of debt and equity. Our results have also some interesting empirical implications: i) They are consistent with the well-documented negative relation between leverage and profitability. ii) Our model predicts that the higher the proportion of low-profitability (bad) firms, the higher the fraction of funds raised through equity. This prediction is consistent with the findings in Fama and French (2005).