Debt, Private Benefits, and Corporate Governance: An Analysis in an Option Valuation Framework

Debt is not frequently analyzed in relation to the conflict between controlling and outside shareholders. At the same time, debt helps to manage the type II corporate agency conflicts because it is easier for controlling shareholders to modify the leverage ratio than to modify their share of capital. A simple model is used to show that debt appears to be a key governance variable because it can moderate private benefits or, conversely, may aid diversion. It is argued in this paper that a self-regulation mechanism may develop even in the situation of control by a dominant shareholder. The joint questions of ownership, private benefits, and debt levels are linked. At low levels of debt, debt is relatively less disciplinary compared with a no private benefit case. When debt exceeds a certain threshold point, it becomes strongly disciplinary. Thus, a self-regulation mechanism develops where the controlling shareholder is incentivized to hold a larger equity stake when he/she wants to increase his/her private appropriation rate.