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Capital Structure Choice When Managers Are in Control: Entrenchment versus Efficiency

  • Walter Novaes

    (Pontifical Catholic University (PUC-Rio))

In the free-cash-flow theory, shareholders use debt to discipline managers and maximize firm value. In contrast, managerial models assume that, without a takeover threat, managers will not lever up to constrain themselves. This article demonstrates that a takeover threat is unlikely to reconcile these two theories. In particular, with low takeover costs, target managers may overlever. Yet, both theories are consistent with recent papers that document a negative correlation between leverage and takeover costs. I propose a test of the two theories by showing that, in the value-maximizing approach, antitakeover amendments reduce the sensitivity of leverage to entrenchment-related variables.

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Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 76 (2003)
Issue (Month): 1 (January)
Pages: 49-82

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Handle: RePEc:ucp:jnlbus:v:76:y:2003:i:1:p:49-82
Contact details of provider: Web page: http://www.journals.uchicago.edu/JB/

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  1. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  2. Raghuram G. Rajan & Luigi Zingales, 1994. "What Do We Know About Capital Structure? Some Evidence from International Data," NBER Working Papers 4875, National Bureau of Economic Research, Inc.
  3. Israel, Ronen, 1991. " Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing," Journal of Finance, American Finance Association, vol. 46(4), pages 1391-1409, September.
  4. Myers, Stewart C., 1984. "Capital structure puzzle," Working papers 1548-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  5. Harris, Milton & Raviv, Artur, 1988. "Corporate control contests and capital structure," Journal of Financial Economics, Elsevier, vol. 20(1-2), pages 55-86, January.
  6. Stewart C. Myers, 1984. "Capital Structure Puzzle," NBER Working Papers 1393, National Bureau of Economic Research, Inc.
  7. MacKie-Mason, Jeffrey K, 1990. " Do Taxes Affect Corporate Financing Decisions?," Journal of Finance, American Finance Association, vol. 45(5), pages 1471-93, December.
  8. Stulz, ReneM., 1990. "Managerial discretion and optimal financing policies," Journal of Financial Economics, Elsevier, vol. 26(1), pages 3-27, July.
  9. Harris, Milton & Raviv, Artur, 1989. "The design of securities," Journal of Financial Economics, Elsevier, vol. 24(2), pages 255-287.
  10. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-64, April.
  11. Stulz, ReneM., 1988. "Managerial control of voting rights : Financing policies and the market for corporate control," Journal of Financial Economics, Elsevier, vol. 20(1-2), pages 25-54, January.
  12. Oliver Hart & John Moore, 1994. "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," NBER Working Papers 4886, National Bureau of Economic Research, Inc.
  13. Myers, Stewart C, 1984. " The Capital Structure Puzzle," Journal of Finance, American Finance Association, vol. 39(3), pages 575-92, July.
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