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RFS Advance Access originally published online on October 15, 2003
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Rev Fin 2004; 17:257-294
© 2004 The Society for Financial Studies

Can Managerial Discretion Explain Observed Leverage Ratios?

Erwan Morellec
University of Lausanne and University of Rochester

Address correspondence to Erwan Morellec, Simon School of Business, University of Rochester, Rochester NY 14627, or e-mail: morellec{at}simon.rochester.edu.

This article analyzes the impact of managerial discretion and corporate control mechanisms on leverage and firm value within a contingent claims model where the manager derives perquisites from investment. Optimal capital structure reflects both the tax advantage of debt less bankruptcy costs and the agency costs of managerial discretion. Actual capital structure reflects the trade-off made by the manager between his empire-building desires and the need to ensure sufficient efficiency to prevent control challenges. The model shows that manager-shareholder conflicts can explain the low debt levels observed in practice. It also examines the impact of these conflicts on the cross-sectional variation in capital structures.


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