Managerial Discretion, Agency Costs, and Capital Structure

Abstract

In a dynamic continuous-time model, we examine the impact of a manager-shareholder conflict over the choice of investment risk on firm value and optimal capital structure. The manager's optimal investment risk policy is substantially different from the policy that maximizes equity or total firm value. The resulting agency costs of equity are many times larger than the agency costs of debt. Among a number of important implications, we find that managerial risk-aversion decreases the agency costs of equity. We also find that when equityholders have control rights over financing decisions, optimal leverage may increase relative to optimal leverage when investment risk is chosen to maximize total firm value. Additionally, greater managerial equity compensation may exacerbate the manager-stockholder conflict over investment policy, and in spite of higher agency costs of equity, may increase optimal leverage. Finally, we find that an increase in risk encourages the manager to pursue a more conservative investment strategy, which increases the agency costs of equity. Managerial risk-aversion, however, acts to mitigate this effect of risk on the agency costs of equity.