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RFS Advance Access originally published online on January 20, 2006
Review of Financial Studies 2006 19(2):605-632; doi:10.1093/rfs/hhj010
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Right arrow G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Capital Structure, Compensation and Incentives

Alan V. S. Douglas
Centre for Advanced Studies in Finance, School of Accountancy

Address correspondence to Alan V. S. Douglas, Centre for Advanced Studies in Finance, School of Accountancy, 289 Hagey Hall, University of Waterloo, Waterloo, Ontario, Canada N2L 3G1, or e-mail: adouglas{at}uwaterloo.ca.

This article illustrates an incentive-aligning role of debt in the presence of optimal compensation contracts. Owing to information asymmetry, value-maximizing compensation contracts allow managerial rents following high investment outcomes. The manager has an incentive to increase these rents by choosing investments that generate greater information asymmetry. An aptly chosen debt level mitigates this incentive, because investments that generate greater information asymmetry have more volatile outcomes. The greater volatility would make the debt risky, causing the shareholders to focus on high outcomes and therefore compensation contracts that reduce managerial rents. At the optimum, the manager avoids opportunistic investments, and the shareholders offer value-maximizing compensation contracts. Empirically, the analysis predicts a negative relationship between leverage and market-to-book that is reversed at extreme market-to-book ratios, a negative relationship between leverage and profitability, a negative relationship between leverage and pay-for-performance, and a positive relationship between pay-for-performance and investment opportunities.


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