Corporate Governance and Capital Structure Dynamics

We develop a dynamic tradeoff model to examine the importance of manager-shareholder conflicts in capital structure choice. In the model, firms face taxation, refinancing costs, and liquidation costs. Managers own a fraction of the firms’ equity, capture part of the free cash flow to equity as private benefits, and have control over financing decisions. Using data on leverage choices and the model’s predictions for different statistical moments of leverage, we find that agency costs of 1.5% of equity value on average are sufficient to resolve the low-leverage puzzle and to explain the dynamics of leverage ratios. Our estimates also reveal that agency costs vary significantly across firms and correlate with commonly used proxies for corporate governance. JEL Classification Numbers: G12, G31, G32, G34. A central theme in financial economics is that incentive conflicts within the firm lead to distortions in corporate policy choices and to lower corporate performance. Because debt limits managerial flexibility (Jensen (1986)), a particular focus of the theoretical research has been on the importance of managerial objectives in capital structure choice. A prevalent view in the literature is that self-interested managers do not make capital structure decisions that maximize shareholder wealth. The capital structure of a firm should then be determined not only by market frictions such as taxes, bankruptcy costs, or refinancing costs (as in Fisher, Heinkel, and Zechner (1989)), but also by the severity of manager-shareholder conflicts. While the impact of agency conflicts on financing decisions has been widely discussed for three decades, the literature has been largely silent on the magnitude of this effect. In addition, although we have learned much from this work, most models in this literature are static, making it difficult to develop tests of the connection between agency conflicts and capital structure dynamics. Our purpose in this paper is to examine the importance of manager-shareholder conflicts in leverage choice and to characterize their effects on the dynamics and cross-section of corporate capital structure. To this end, we develop a dynamic tradeoff model that emphasizes the role of agency conflicts in firms’ financing decisions. The model features corporate and personal taxes, refinancing and liquidation costs, and costly renegotiation of debt in distress. In the model, each firm is run by a manager who sets the firm’s financing, restructuring, and default policies. Managers own a fraction of the firms’ equity and can capture part of free cash flow to equity as private benefits within the limits imposed by shareholder protection. Debt constrains the manager by reducing the free cash flow and potential cash diversion (as in Jensen (1986), Zwiebel (1996), or Morellec (2004)). In this environment, we determine the optimal leveraging decision of managers and characterize the effects of manager-shareholder