Executive Incentive Plans, Corporate Control, and Capital Structure

Abstract

Agency theory recognizes that the interests of managers and shareholders may conflict and that, left on their own, managers may make major financial policy decisions, such as the choice of a capital structure, that are suboptimal from the shareholders' standpoint. The theory also suggests, however, that compensation contracts, managerial equity investment, and monitoring by the board of directors and major shareholders can reduce conflicts of interest between managers and shareholders. This research investigates the relationship between the firm's capital structure and 1) executive incentive plans, 2) managerial equity investment, and 3) monitoring by the board of directors and major shareholders. This paper finds a positive relationship between the firm's leverage ratio and 1) percentage of executives' total compensation in incentive plans, 2) percentage of equity owned by managers, 3) percentage of investment bankers on the board of directors, and 4) percentage of equity owned by large individual investors. These findings are consistent with the predictions of agency theory, suggesting, in turn, that capital structure models that ignore agency costs are incomplete.