Idiosyncratic risk, managerial discretion and capital structure

Abstract

This paper develops an integrated dynamic model to examine the impact of managerial compensation packages, namely, cash salary and ownership stake, and reservation income on the credit spreads and capital structure choice of a risk-averse manager who faces incomplete markets and costly effort. Our model predicts an inverted U-shaped relationship between credit spreads (market leverage) and managerial ownership stake, which reconciles empirical findings that are inconsistent with previous theories. Moreover, in contrast to the predictions of previous models, we find that credit spreads decrease with the manager's cash salary, whereas they increase with the manager's reservation income. Finally, we also demonstrate that the relationship between pay-performance sensitivity (PPS) and the firm's market leverage is dependent on the manager's ownership stake and cash salary; this prediction provides novel empirical tests.