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Conflicts between Managers and Investors over the Optimal Financial Contract

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  • Richard Fairchild

    (Department of Corporate Finance, University of Bath, U.K.)

Abstract

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.

Suggested Citation

  • Richard Fairchild, 2003. "Conflicts between Managers and Investors over the Optimal Financial Contract," International Journal of Business and Economics, College of Business and College of Finance, Feng Chia University, Taichung, Taiwan, vol. 2(3), pages 197-212, December.
  • Handle: RePEc:ijb:journl:v:2:y:2003:i:3:p:197-212
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    References listed on IDEAS

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    1. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
    3. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
    4. Philippe Aghion & Patrick Bolton, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 473-494.
    5. Stein, Jeremy C, 1996. "Rational Capital Budgeting in an Irrational World," The Journal of Business, University of Chicago Press, vol. 69(4), pages 429-455, October.
    6. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, pages 323-329.
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    Cited by:

    1. Dimitrios I. Maditinos & Alexandra V. Tsinani & Željko Šević, 2015. "Managerial optimism and the impact of cash flow sensitivity on corporate investment: The case of Greece," International Journal of Business and Economic Sciences Applied Research (IJBESAR), Eastern Macedonia and Thrace Institute of Technology (EMATTECH), Kavala, Greece, vol. 8(2), pages 35-54, October.

    More about this item

    Keywords

    financial contracting; moral hazard; equity ownership; financial distress;

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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