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Debt finance and the cost of management ownership: Some elementary results
Author(s) -
Garvey Gerald T.
Publication year - 1995
Publication title -
managerial and decision economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.288
H-Index - 51
eISSN - 1099-1468
pISSN - 0143-6570
DOI - 10.1002/mde.4090160106
Subject(s) - agency cost , debt , incentive , free cash flow , liberian dollar , finance , leverage (statistics) , cash flow , equity (law) , business , monetary economics , equity value , stock (firearms) , shareholder , economics , internal debt , microeconomics , debt levels and flows , corporate governance , machine learning , computer science , political science , law , mechanical engineering , engineering
Increased debt reduces a company's equity base, which reduces the dollar investment a manager must make to hold a given proportion of stock. Therefore, it is often argued, managers' effort incentives are improved by high leverage. This paper shows that while risky debt reduces the cost of providing managers with substantial equity ownership, the cheaper equity captures less of the fruits of the manager's effort. Managers' effort incentives are improved by high debt levels only under quite restrictive conditions. These conditions are more plausible when agency problems are due to a managerial propensity to expand size by investing in negative net present value projects. The results also imply that when debt is increased to reduce the agency costs of free cash flow, the accompanying covenants should allow for substantial cash distributions to shareholders even before bondholder claims are satisfied.