Capital structure and short-term decisions

Dermot Nolan

Oxford Economic Papers, 2002, vol. 54, issue 3, 470-489

Abstract: Share price pressure can lead to managerial myopia as managers face incentives to make short-run decisions. We show how long-run debt can negate myopic behavior by serving as an incentive to have high future earnings in order to avoid the risk of bankruptcy. We show how increases in leverage could have been a signal in response to growing share price pressure in the 1980s. We obtain a theory of capital structure whose predictions are in line with recent empirically observed patterns. We demonstrate the benefits of high bankruptcy penalties in inducing efficient decision making, and show how debt may, ex post, lead to inefficient decisions being taken in an effort to pay it off. This ex post consequence of debt can potentially undermine its ex ante incentive benefits. Copyright 2002, Oxford University Press.

Date: 2002
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