Irreversible investment, managerial discretion and optimal capital structure

Abstract

We explore the significance of employee compensation and alternative (reservation) income on investment timing, endogenous default, yield spreads and capital structure. In a real-options setting, a manager’s incentive to under(over)invest in a project is associated to labor income he has to forego in order to work on the project, the manager’s salary, his stake on the project’s equity capital and his subsequent income, should he decide to terminate operations. We find that the optimal level of coupon payments decreases with managerial salary and ownership stake while it is increasing in the manager’s reservation income. Yield spreads (optimal leverage ratios) are increasing (decreasing) in the manager’s salary and ownership stake, while they are decreasing (increasing) in the manager’s reservation income. Exploring agency costs of debt as deviations from a value-maximizing investment policy, we document a U-shaped relationship between agency costs of debt and the managerial compensation parameters: the manager’s reservation income, salary and ownership share.