18.4Capital Structure and Managerial Control

As noted earlier, a manager may prefer less than the optimal level of debt because addi-

tional debt increases the risk of bankruptcy and limits a manager’s discretion. In some

circumstances, however, outside shareholders might view these factors as advantages.

The added debt may prevent a manager from expanding the firm more rapidly than

would be optimal. Moreover, since higher debt ratios increase the threat of bankruptcy,

which managers are anxious to avoid, increased debt can induce management to avoid

policies they might personally prefer but which reduce firm value.¹²The basic idea is

that the fear of losing one’s job is a good motivator. In an article in Business Week,

Holiday Corporation Chairman Michael D. Rose expressed the advantage of debt

financing clearly:

When you get higher levels of debt it really sharpens your focus... It makes for better

managers since there is less margin for error.¹³

Therefore, the shareholders of a firm that is run by “self-interested” management may

prefer a higher leverage ratio than one would find in firms that are managed in the

shareholders’interest.

The Relation between Shareholder Control and Leverage

Mehran (1992) provided evidence supporting the idea that control by outside share-

holders affects how firms are financed. In his sample of 124 manufacturing firms,

Mehran found a positive relation between a firm’s leverage ratio and:

12

This argument was made by Grossman and Hart (1982).

¹³“Learning

to Live with Leverage,” Business Week,Nov. 7, 1988.

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Strategy, Second Edition		Decisions

640	Part VIncentives, Information, and Corporate Control

•	The percentage of total executive compensation tied to performance.
•	The percentage of equity owned by managers.
•	The percentage of investment bankers on the board of directors.
•	The percentage of equity owned by large individual investors.

In other words, firms tend to be more highly leveraged if they are managed by

individuals with a strong interest in improving current stock prices or if they are mon-

itored by board members or large shareholders who have those interests.

Result 18.6

Shareholders prefer a higher leverage ratio than that preferred by management. As a result,firms that are more strongly influenced by shareholders have higher leverage ratios.

How Leverage Affects the Level of Investment

Chapter 16 discussed how debt financing could limit the amount that a firm invests.

However, if management has a tendency to overinvest, then limiting management’s abil-

ity to invest may enhance firm value.¹⁴

Tom and Charley’s Victorian Rehab: Using Debt to Limit Future Investments

To understand why an investor might want to use debt to limit a firm’s investment oppor-

tunities, consider the case of Tom and Charley, former college roommates. One after-

noon Tom, who had become an architect, called Charley, an investment banker, with a

proposal to buy an old Victorian house to convert into apartment units. Tom estimated

that the total cost of the house and the rehabilitation would be about $200,000. As the

project’s architect, Tom would receive a small fee from the profits, and he would have

complete control over the project once it was financed. Charley was asked to come up

with the best financing alternatives.

Charley carefully calculated the project’s net present value. After considering several pos-

sible scenarios, he concluded that Tom’s assessment of the project’s potential was reason-

ably accurate. Charley then considered financing alternatives and settled on a fixed-rate

mortgage as the best alternative. The next question was to determine how much to borrow

and how much of their own money to invest in the project.

Both Tom and Charley have $25,000 to invest in the project. Tom would prefer to invest

his entire $25,000 since his alternative is to put the money in a bank CD paying 5.5 per-

cent interest and the mortgage rate would be 7 percent. Charley has no good alternatives

for his $25,000, but he has one reservation about putting up such a large down payment on

the house. With a large down payment, the monthly payments would be much lower, so

Tom would face much less pressure to cut costs and increase cash flows. With a large equity

investment, Charley also could easily secure an additional loan to make further renovations.

Although Charley trusts Tom completely, he realizes that Tom has the tendency to make his

projects perfect, regardless of costs. For this reason, Charley believes that the project should

have a smaller down payment and a larger loan.

This example illustrates one very important point:

Result 18.7

Alarge debt obligation limits management’s ability to use corporate resources in ways thatdo not benefit investors.

Selecting the Debt Ratio That Allows a Firm to Invest Optimally.Chapter 16 dis-

cussed how too much debt may force a firm to pass up some positive net present value

projects. The debt overhang problemindicates that a firm that chooses a high debt ratio

will find the costs of obtaining additional funds high, reducing the amount that equity

14

See Jensen (1986) and Stulz (1990).

Grinblatt1294Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1294Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 18

How Managerial Incentives Affect Financial Decisions

641

holders will want the firm to invest. The analysis in this section suggests that outside

shareholders may be able to use this debt overhang problem to their advantage. When

managers have a tendency to overinvest, debt financing can be used to mitigate that

tendency.¹⁵Example 18.3 illustrates how this can be done.

Example 18.3:Selecting the Debt Ratio That Leads to the Optimal Investment

Strategy

Consider a firm that is financed with an initial investment of $100 million.In exactly one year,

it must decide whether to go ahead with a project that requires an additional $100 million

investment.The present values (at the end of the first year) of the payoffs from taking or not

taking the additional investment in three future states of the economy are given in the fol-

lowing table:

Value (in $ millions) When

State of the Economy Is

Good

Medium

Bad

Value with investment	$250	$175	$125
Value without investment	50	50	50

One year from now, if in either the good or medium states, the additional investment has

a positive NPV;that is, it creates more than $100 million in value in the good and medium

states.In the bad state, however, where only $75 million ($125 million–$50 million) is cre-

ated by taking the investment, the additional investment has a negative NPV.

Assume that when financing the investment at the beginning of year 1, the original

entrepreneurs understand that the manager they hire will want to fund the new investment

at the end of year 1, even if it has a negative NPV.How should they finance the original

investment to ensure that the firm can raise sufficient funds only when the additional

investment has a positive NPVat the end of year 1?

Answer:If the original $100 million investment is financed completely with equity, the

additional investment can be funded by issuing debt even in the bad state of the economy.

To keep the managers from funding the additional investment in the bad state of the econ-

omy, the firm can finance partof the original investment with senior debt that requires addi-

tional debt to be of lower priority.Note that if the original investment at the beginning of year

1 is financed completelywith senior debt, the firm will be unable to finance the additional

$100 million dollar investment in the medium state of the economy.(Since the original $100

million dollar investment must be paid first in the medium state of the economy, only $75

million is left to pay the new investors.) In this case, a positive NPVproject is passed up.

However, if the firm issues more than $25 million in senior debt but less than $75 million, it

will be able to finance the project in the good and medium states of the economy but not in

the bad state of the economy.

The outside shareholders in Example 18.3 were able to induce the firm’s managers

to invest exactly the right amount by selecting the appropriate debt ratio. In reality,

however, things may not work out as nicely. For one thing, Example 18.3 ignores the

possibility that the firm also has internally generated funds to invest in the project. This

does not necessarily cause a problem if the firm generates cash in those states of the

¹⁵These

ideas were developed in Jensen (1986), Stulz (1990), and Hart and Moore (1995).

Grinblatt1296Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1296Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

642Part VIncentives, Information, and Corporate Control

economy in which it has positive NPVinvestments. However, as Example 18.4

illustrates, if the firm generates a substantial amount of cash when its investments have

negative NPVs, it may not be possible to induce managers to invest the optimal amount

in every state of the economy by simply selecting the appropriate capital structure.

Example 18.4:Can Financing Choices Always Be Used to Achieve the Optimal