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

Alan V. Douglas

Review of Finance, 2002, vol. 6, issue 1, 63-99

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 asymmetryrequires 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 inprevious studies result endogenously. If the problems exist simultaneously, dividends can beoptimal 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. JEL classification codes: G30, D82

Date: 2002
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