The Effect Of Capital Structure When Expected Agency Costs Are Extreme
The Effect of Capital Structure when Expected Agency Costs are Extreme
Harvey, C.R. Lins, K.V. Roper, A.H.
Journal of Financial Economics 74 (2004) 3-30
RESEARCH MOTIVATION
The objective of this paper is, using international evidenceto investigate whether debt can mitigate the effects of agency and information problems.
Prior theoretical research has shown that debt can be used to align managers’ interest. More specifically, when a meaningful conflict exists between outside shareholders and management due to the separation of ownership and control, debt helps to discourage overinvestment of free cash flow by self-serving managers (Jensen Meckling [1976], Jensen [1986] Stulz [1990] and else). Moreover, even without conflicting interest, debt gives management the opportunity to signal its willingness to pay out cash flows or be monitored by lenders or both, and thus to show that they do not or will not overinvest (Ross [1977] and else).
Benefits to debt could be greater (1) when management has a large base of assets in place that it can exploit, because assets in place generate cash flow that can lead to either overinvestment or the outright diversion of corporate funds (Jensen [1986] and else) or (2) when management has few future growth opportunities, because when a firm has expected future growth opportunities, debt can limit management’s ability to pursue positive net present value projects, leading to ex-post underinvestment (Myers [1977]).
Harvey et al adopted a refined setting. In particular, they focused on emerging markets and international debt markets. In emerging markets, managers and families routinely employ pyramid ownership structures to give themselves control rights that far exceed their proportional cash flow ownership, and consequently there potentially exist extreme