Dynamic Capital Structure under Managerial Entrenchment: Evidence from a Structural Estimation

This paper examines the impact of managerial entrenchment on corporate financing decisions. We build a dynamic contingent claims model in which financing policy results from a trade-off between tax benefits, agency conflicts, and contracting frictions. In our setting, managers do not act in the best interest of shareholders, but rather pursue private benefits at the expense of shareholders. Managers have discretion over financing and dividend policies. However, shareholders can remove the manager at a cost. Our analysis demonstrates that entrenched managers restructure less frequently and issue less debt than optimal for shareholders. We take the model to the data and use observed financing choices to provide firm-specific estimates of the degree of managerial entrenchment. Using structural econometrics, we find that costs of control challenges of 2-7% on average (.8- 5% at median) are sufficient to resolve the low-and zero-leverage puzzles and explain the time series of observed leverage ratios. Our estimates of the agency costs vary with variables that one expects to determine managerial incentives. Governance mechanisms significantly affect the value of control and firms’ financing decisions.