Impact of financial constraint on incentive compensation and product market behavior

This paper introduces financing constraint in a model of incentive compensation and product market and develops key insights about the interactions of product market behavior, financial constraint and incentive compensation. A financially constrained firm faces higher cost of capital which results in lower output. The model suggests that a financially constrained firm offers higher incentive compensation to its manager if the degree of product differentiation is sufficiently low. This higher incentive encourages the manager to put more effort and produce more output in order to compensate for the loss in output due to financial constraint. Our paper generates the testable hypothesis that a financially constrained firm will offer higher incentive compensation to its manager which has not yet been tested empirically.