Dynamic Compensation Contracts and Capital Structure under Loss Aversion

In this paper, we adapt a continuous-time agency model to incorporate the loss-aversion preferences of agents. To this end, by distinguishing between the gains in capital and income driven by variations in the agent's continuation payoff, we provide a theoretical model which overcomes the problem that the loss of utility arising from loss aversion disappears entirely with a continuous-time limit. We then show that the optimal contract includes part that is strictly positive but insensitive to the agent's continuation payoff, and part that encompasses a range of option-type payoffs. Implementing the optimal contract using a combination of equity, long-term debt, and a line of credit, we also predict that dividend payments are insensitive to changes in the firm's performance as long as its performance is moderately good. In addition, we derive some relations between dividends, the credit line balance (equity value), the limit of the credit line, and long-term debt. These results provide a unified explanation for the evolution of CEO compensation and corporate dividend-smoothing policy. The results also yield several predictions about dynamic capital structure in line with the empirical literature. In terms of robustness, the endogenous determination of the utility reference point does not greatly affect our main results