Capital Structure and Short Term Decisions

Dermot Nolan
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Dermot Nolan: Department of Economics, Royal Holloway, University of London

No 9810, Royal Holloway, University of London: Discussion Papers in Economics from Department of Economics, Royal Holloway University of London

Abstract: Share price pressure can lead to managerial myopia as managers face incentives to make short-run decisions as modelled in Stein (1989). We show how long-run debt can negate myopic behaviour by serving as an incentive to have high future earnings in order to avoid the risk of costly bankruptcy. The model shows how increases in leverage were a signal in response to growing share price pressure in the 1980s. It yields a theory of capital structure whose predictions are in line with recent empirically observed patterns, unlike the previous signalling models such as those of Myers and Ross. The model also predicts the recent series of corporate bankruptcies, and it demonstrates the benefits of high bankruptcy penalties in inducing efficient decision making. It then shows 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.

Pages: 39 pages
Date: 1998-02, Revised 1998-02
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