Top-Management Compensation and Capital Structure




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    • The authors are from the Stern School of Business, New York University. The paper has benefited from the comments of Yakov Amihud, James Brickley, Jeff Coles, Stuart Gilson, Steven Kaplan, Han Kim, Robert Lippert, Hamid Mehran, M. P. Narayanan, Jonathan Paul, Ronen Israel, Joshua Ronen, Lemma Senbet, Badih Soubra, and Marti Subrahmanyam, seminar participants at New York University and the University of Michigan, conference participants at the 1992 American Accounting Association Meetings, 1992 American Finance Association Meetings, and the 1993 Conference on Optimal Security Design and Innovations in Financing (Rutgers University). We are especially grateful to Rick Antle, Hayne Leland, Kevin Murphy, and an anonymous referee for extensive comments on an earlier draft. Financial support was provided by Stern School summer research grant (Teresa John) and a Bank and Financial Analysts Faculty Fellowship (Kose John).


The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device to minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negative relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy (1990) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization.