Agency Costs, Risk Management, and Capital Structure


  • Hayne E. Leland

    1. Haas School of Business, University of California, Berkeley
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    • Haas School of Business, University of California, Berkeley. This article is a revised version of my Presidential Address to the American Finance Association meeting in Chicago, Illinois in January 1998. I thank Samir Dutt, Nengjiu Ju, Michael Ross, and Klaus Toft both for computer assistance and for economic insights. My intellectual debts to professional colleagues are too numerous to list, but are clear from the references cited. Any errors remain my sole responsibility.


The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered.

Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.