Endogenous Managerial Incentives and the Optimal Combination of Debt and Dividend Commitments

Abstract

This paper studies the optimal combination of debt and dividend commitments in an agency model of the firm. Financial policy is relevant because ex-post information asymmetry requires managerial rewards to depend on the ability to meet financial commitments. If perquisite or inside information problems exist in isolation, debt-based incentives as assumed in previous studies result endogenously. If the problems exist simultaneously, dividends can be optimal even when they appear excessively costly as a signal and unduly lenient as a disciplining device. The reason is that the set of dynamically consistent rewards increases when debt commitments are augmented with dividend commitments, and a larger set of ex-post rewards is more valuable as ex-ante decisions become more complex. Managerial Incentives and the Optimal Combination of Debt and Dividend Commitments This paper studies the choice between debt and dividend payments as methods to disburse cash from the firm. With the frictionless capital markets underlying the MM capital structure and dividend irrelevance theorems, 1 the substitution of debt for equity (or interest payments for dividend payments) does not affect firm value. With taxation and bankruptcy costs (legal, reputation and opportunity costs), both debt and dividend levels become relevant. Indeed, the substantial tax implications have led to the 'capital structure puzzle' (that interest payments are not increased to take advantage of interest deductibility in the corporate tax code; Myers 1984) and the 'dividend puzzle' (that dividend payments are not decreased to take advantage of the relatively low taxation of capital gains in the personal tax code; Black 1976). 2 1 Modigliani and Miller (1958) and Miller and Modigliani (1961), respectively. 2 There is a large literature on the indirect costs of financial distress (see John 1993). The ex-ante cost of debt, however, remains low due to low probabilities of bankruptcy (e.g., Altman (1984) estimates the sum of direct and indirect costs at 11-17% of value for bankrupt U.S. firms, and Burgstahler