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Leverage Choice and Credit Spread Dynamics when Managers Risk Shift

Author

Listed:
  • Murray Carlson

    () (Commerce and Business Administration University of British Columbia)

  • Ali Lazrak

Abstract

We develop a structural model of the leverage choices of risk-averse managers who are compensated with cash and stock. We further characterize credit spread dynamics over the life of the debt. Managers optimally balance the tax benefits of debt with the utility cost that results from their ex-post asset substitution choices. Our model predicts the existence of a U-shaped relationship between the cash component of pay and leverage levels: when cash compensation is low, safe debt with a high face value is issued and when cash compensation is high, risky debt with a high face value is issued. At moderate levels of the cash-to-stock value ratio low leverage is chosen but credit spreads can be significant and again relate to compensation terms. The model illustrates the quantitative importance of including agency costs in the tradeoff theory of capital structure

Suggested Citation

  • Murray Carlson & Ali Lazrak, 2006. "Leverage Choice and Credit Spread Dynamics when Managers Risk Shift," 2006 Meeting Papers 193, Society for Economic Dynamics.
  • Handle: RePEc:red:sed006:193
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit Spreads; Capital Structure; Agency Costs of Debt;

    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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