Alan V. S. Douglas

Capital structure and the control of managerial incentives

Abstract We present a theory of capital structure based on the power of shareholders, bondholders and managers to control the incentive conflicts in large corporations. The manager–owner conflict produces a trade-off between inefficiency in the low state and rents in the high state, and the shareholder–bondholder conflict produces under-investment as in Myers [Journal of Financial Economics 19 (1997) 147]. Since managers and bondholders both prefer more efficient actions in the low state, the two conflicts are interdependent. With risk-less levels of debt, there are no shareholder–bondholder agency costs, but managerial control over the incentive-setting process produces excessive rents. With risky debt, shareholders focus more on returns in the high state so that shareholder–bondholder agency costs increase but managerial rents decrease. Efficient levels of debt holder protection facilitate a reduction in manager–owner agency costs that outweighs shareholder–bondholder agency costs, and are decreasing in firm performance. The results are consistent with the separate empirical results relating control to both compensation and leverage, and suggest how future studies can be integrated.

Corporate Investment Incentives and Accounting‐Based Debt Covenants*

This paper studies the conditions under which accounting-based debt covenants increase firm value in a setting that incorporates the conflicting incentives of shareholders, bondholders, and managers. We construct a model in which debt is needed to discipline managerial investment decisions despite endogenous compensation contracts. We show that accounting covenants increase value when (1) debt serves as a credible commitment to penalize poor investment decisions; (2) the firm faces other (exogenous) sources of uncertainty that can make debt risky despite good investment decisions; and (3) accounting information serves as a contractible proxy for firms economic performance. In these circumstances, accounting covenants ensure that shareholders do not offer compensation schemes that would encourage bondholder wealth expropriation when the debt becomes risky. A covenant specifying a required level of accounting performance provides additional bondholder power when performance is low. An accounting-based dividend covenant allows a disbursement to maintain investment incentives when performance is high without allowing dividend-based expropriation. The optimal covenants depend on the reliability of accounting information, and the interaction between accounting performance and the different incentive conflicts provides new insight into the empirical literature on accounting-based covenants.

Managerial opportunism and proportional corporate payout policies

Purpose - The purpose of this paper is to investigate the relative preference for dividends vs share repurchases based on managers’ personal wealth and control benefits. Design/methodology/approach - The paper presents an analytical model of managerial preferences and information advantages, and analyses how the choice between dividends and repurchases relates to the managers personal objectives in this setting. The approach specifies preferences consistent with the agency theory of economics. Findings - It is found that, when managers can influence share price prior to a repurchase, due to their superior information, repurchases present an opportunity to increase managerial wealth relative to dividends. In addition, if managers can influence the post-repurchase share price, due to an upward sloping supply curve for the companys stock, repurchases present an opportunity to protect the managers’ personal benefits of control. The ability to protect control depends on the toehold purchased by potential acquirers, and on the source of the upward-sloping supply. Repurchases are less protective when toeholds are small and the supply curve reflects tax lock-in effects. Practical implications - The results indicate that managerial concerns over their personal wealth or ability to maintain control of the firm can influence the method of corporate distributions. As such, market valuations and the market reaction to distribution announcements may reflect these managerial concerns. This could be an important determinant of investor stock choices. Originality/value - The factors determining firms’ payout methods remains a topic of significant importance and debate. The method of analysis here is new, and the insights into managerial preferences, toeholds and payout decisions help to inform this debate.

Managerial replacement and corporate financial policy with endogenous manager-specific value

Abstract This paper studies financial policy, investment decisions and the threat of dismissal when managers value control and investments generate manager-specific value. A high probability of investigation focuses the manager on the profitability of replacement and therefore manager-specific value. The probability of an investigation increases when the firm enters bankruptcy. Thus, high debt levels focus the manager on investments that dissuade replacement during bankruptcy procedures. Dividends relax the managers focus on manager-specific value since there is a lower probability of an investigation following a missed dividend. The ability to make dividend payments, however, is related to ex-post performance and can improve replacement decisions. When managerial quality is commonly known, the expected value of the firm is maximized with a combination of debt and dividend commitments. When managerial quality is hidden information, it is optimal for the combination of debt and dividend commitments to signal quality.

Investment Banking in China: Past, Present and Future

China’s economy has been growing rapidly since the late 1970s and is expected to maintain this momentum in the foreseeable future. Coupled with the biggest population in the world, there is tremendous growth potential for China’s capital markets and financial services industry, both vital to the continued development of the economy. The contributors present research on all facets of China’s markets including: stock and bond markets; futures and over-the-counter markets; regulatory issues; and the development and roles of financial institutions such as brokerage firms, banks and insurance companies. Also addressed are the recent performance of equity markets, the emergence of small and medium enterprises, and the state banks’ bids to be listed in overseas stock exchanges. Taken together, the book sheds a welcome light on China’s overall economic growth.