Conflicts between Managers and Investors over the Optimal Financial Contract

We develop a principal-agent model of financial contracting in which investors face moral hazard problems relating to managerial effort. The level of debt potentially mitigates these problems in two ways. For high debt levels, the manager owns more of the equity, and also the threat of financial distress increases. In the absence of financial distress costs, we derive a novel irrelevance result; the financial contract does not affect managerial effort or firm value. Therefore, the manager and the investors are indifferent between a high debt and low debt contract. In the presence of financial distress costs, the manager has an incentive to increase his effort level in order to reduce the threat of distress. Now investors unambiguously prefer the (value-maximising) high debt contract. When effort costs and financial distress costs are low, the manager also prefers the high debt contract. When effort costs and financial distress costs are high, the manager prefers the (value-minimising) low debt contract.