Managerial Compensation and Capital Structure

Abstract

We investigate the interaction between financial structure and managerial compensation in the context of a managerial entrenchment model in the spirit of Shleifer and Vishny (1989). We show that risky debt affects both the probability of managerial replacement and the manager's wage if he is retained by the firm. Our model yields a rich set of predictions including the following: The market values of equity and debt decrease if the manager is replaced. Moreover, the expected cash flow of firms that retain their managers exceeds that of firms that replace their managers. Firms that publicly announce the adoption of a new managerial compensation plan should experience positive price reactions in the capital market as well as strong positive performance following the adoption. Managers of firms with risky debt outstanding are promised lower severance payments (golden parachute) than managers of firms that do not have risky debt. Controlling for firm's size, leverage, managerial compensation, and the cash flow of firms that retain their managers are positively correlated. Controlling for firm's size, the probability of managerial turnover and firm value are negatively correlated.