Joint Determination of Leverage and Managerial Incentive Compensation: Theory and Evidence

This paper investigates how capital structure and managerial compensation are jointly determined within a contingent claims model where the two interact through manager-stockholder and stockholder-bondholder conflicts. In the presence of frictions, agency conflicts affect investment decisions and, hence, firm value. Rational stockholders set financial policies and managerial compensation simultaneously, to minimize the distortion caused by these conflicts. This joint optimization creates a tradeoff between leverage and managerial incentive compensation: equity holders would avoid setting both high. The model predicts that due to the tradeoff between the two, key firm characteristics should move the two in opposite directions. This article also reports empirical evidence strongly supporting the model by estimating simultaneous equations of market leverage and pay-performance sensitivity. The negative correlation between the two dependent variables is captured in the opposite effects from key firm characteristics. After controlling for the tradeoff, market leverage and pay-performance sensitivity have a positive relation.