Leverage Choice and Credit Spread Dynamics when Managers Risk Shift

Murray Carlson () and Ali Lazrak
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Murray Carlson: Commerce and Business Administration University of British Columbia

No 193, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: We develop a structural model of the leverage choices of risk-averse managers who are compensated with cash and stock. We further characterize credit spread dynamics over the life of the debt. Managers optimally balance the tax benefits of debt with the utility cost that results from their ex-post asset substitution choices. Our model predicts the existence of a U-shaped relationship between the cash component of pay and leverage levels: when cash compensation is low, safe debt with a high face value is issued and when cash compensation is high, risky debt with a high face value is issued. At moderate levels of the cash-to-stock value ratio low leverage is chosen but credit spreads can be significant and again relate to compensation terms. The model illustrates the quantitative importance of including agency costs in the tradeoff theory of capital structure

Keywords: Credit Spreads; Capital Structure; Agency Costs of Debt (search for similar items in EconPapers)
JEL-codes: G32 (search for similar items in EconPapers)
Date: 2006
New Economics Papers: this item is included in nep-bec
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Citations: View citations in EconPapers (1)

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