Corporate Governance and Capital Structure Dynamics

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday January 20, 2012 at 9:38 am
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Editor’s Note: The following post comes to us from Erwan Morellec, Professor Finance at Ecole Polytechnique Fédérale de Lausanne; Boris Nikolov of the Department of Finance at the University of Rochester; and Norman Schürhoff, Professor of Finance at the University of Lausanne.

In our paper, Corporate Governance and Capital Structure Dynamics, forthcoming in the Journal of Finance, we examine the importance of manager-shareholder conflicts in capital structure choice and characterize their effects on the dynamics and cross section of corporate capital structure. To this end, we develop a dynamic tradeoff model that emphasizes the role of agency conflicts in firms’ financing decisions. The model features corporate and personal taxes, refinancing and liquidation costs, and costly renegotiation of debt in distress. In the model, each firm is run by a manager who sets the firm’s financing, restructuring, and default policies. Managers act in their own interests and can capture part of free cash flow to equity as private benefits within the limits imposed by shareholder protection. Debt constrains the manager by reducing the free cash flow and potential cash diversion (as in Jensen, 1986, Zwiebel, 1996, or Morellec, 2004). In this environment, we determine the optimal leveraging decision of managers and characterize the effects of manager-shareholder conflicts on target leverage and the pace and size of capital structure changes.

As in prior dynamic tradeoff models, our analysis emphasizes the role of capital market frictions in the dynamics of leverage ratios. Due to refinancing costs, firms are not able to keep their leverage at the target at all times. As a result, leverage is best described not just by a number, the target, but by its entire distribution—including target and refinancing boundaries. The model also reflects the interaction between market frictions and manager-shareholder conflicts, allowing us to generate a number of novel predictions relating agency conflicts to the firm’s target leverage, the frequency and size of capital structure changes, the speed of mean reversion to target leverage, and the likelihood of default. Notably, we show that when making financing decisions, the manager trades off the tax benefits of debt against the total costs of debt, which include not only the costs of financial distress but also those associated with the disciplining effect of debt. As a result, incentive conflicts between managers and shareholders lower the firm’s target leverage and its propensity to refinance. That is, the range of leverage ratios widens and financial inertia becomes more pronounced as manager-shareholder conflicts increase.

We explore the empirical implications of our dynamic capital structure model in two ways. First, we use a basic calibration to show that while dynamic models without agency conflicts produce the right qualitative effects to explain the data, transaction costs alone have too small effects on debt choices to explain the low debt levels and slow mean reversion of debt observed empirically. We also show with this calibration that by adding reasonable levels of agency conflicts and giving the manager control over the leverage decision, one can obtain capital structure dynamics consistent with the data.

Second, we use panel data on observed leverage choices and the model’s predictions for different statistical moments of leverage to obtain firm-specific estimates of agency costs. We exploit not only the conditional mean of leverage (as in a regression) but also the variation, persistence and distributional tails—in short, the conditional moments of the time-series distribution of leverage. Using structural econometrics, we find that agency costs of 1.5% of equity value on average (0.45% at median) are sufficient to resolve the low-leverage puzzle and to explain the time series of observed leverage ratios. We also find that the variation in agency costs across firms is substantial. Thus, while leverage ratios tend to revert to the (manager’s) target leverage over time, the variation in agency conflicts leads to persistent cross-sectional differences in leverage ratios. Finally, we show that the levels of agency conflicts inferred from the data correlate with a number of commonly used proxies for corporate governance, thereby providing additional support for the agency cost channel in explaining financing decisions.

The full paper is available for download here.

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