Endogenous Managerial Incentives and the Optimal Combination of Debt and Dividend Commitments

This paper studies the optimal combination of debt and dividend commitments in an agency model of the firm. Financial policy is relevant because ex-post information asymmetry requires managerial rewards to depend on the ability to meet financial commitments. If perquisite or inside information problems exist in isolation, debt-based incentives as assumed in previous studies result endogenously. If the problems exist simultaneously, dividends can be optimal even when they appear excessively costly as a signal and unduly lenient as a disciplining device. The reason is that the set of dynamically consistent rewards increases when debt commitments are augmented with dividend commitments, and a larger set of ex-post rewards is more valuable as ex-ante decisions become more complex.