Influence Costs and Capital Structure

Abstract

ABSTRACTThis paper analyzes the role of capital structure in the presence of intrafirm influence activities. The hierarchical structure of large organizations inevitably generates attempts by members to influence the distributive consequences of organizational decisions. In corporations, for example, top management can reallocate or eliminate quasi rents earned by their employees, while at the same time, they must rely on these employees to provide them with information vital to their decision making. This creates the opportunity for lower level managers to influence top management's discretionary decisions. As a result, divisional managers may attempt to inflate the corporate perception of their relative contributions to the firm, or to take actions that make the elimination of their rents more costly for the firm. This incentive to influence is especially acute when managers fear losing their jobs, for example in the event of a divestiture.Since the firm's capital structure can affect future divestiture decisions, it can be chosen to reduce or increase the divisional managers' incentives to influence top management's decisions. The control of influence activities arises at the expense of restrictions on future divestiture decisions. Hence, there emerges an optimal capital structure that trades off the costs of influence activities against the costs of making poor divestiture decisions. The findings suggest that capital structure can also be chosen to control influence activities that arise under less extreme motivations.We identify several key factors that determine the optimal capital structure: the top management's prior assessment of the likelihood that it will be optimal to divest a specific division; the costs of influence activities to the firm and to the divisional managers; and the difference in the valuation of the division's assets in the current firm and under alternative uses.