Capital Structure under Heterogeneous Beliefs and Agency Conflicts

This paper investigates the effects of heterogeneous beliefs about future firm earnings and agency conflicts on corporate capital structure. We develop a dynamic structural model in which the manager of a firm has discretion in financing and effort and receives dynamic incentives through an explicit contract with shareholders in the presence of heterogeneous beliefs between the two parties. The manager’s optimal contract implemented through financial securities leads to the firm’s dynamic, incentive-driven capital structure. Accordingly, the theoretical and numerical analyses of the model generate several implications on the firm’s capital structure: (i) Long-term debt declines with managerial optimism, while short-term debt increases with it; (ii) Long-term debt (Short-term debt) decreases (increases) with transient earnings risk, but increases (decreases) with intrinsic earnings risk; (iii) Equity value is negatively affected by managerial optimism, but positively affected by intrinsic earnings risk. Our analysis suggests that managerial optimism and transitory and permanent risk factors are important determinants of firms’ optimal financial policies. JEL Classification: G32