We develop a principal-agent model of financial contracting in
which investors face moral hazard problems relating to managerial
effort. The level of debt potentially mitigates these problems in
two ways. For high debt levels, the manager owns more of the
equity, and also the threat of financial distress increases. In
the absence of financial distress costs, we derive a novel
irrelevance result; the financial contract does not affect
managerial effort or firm value. Therefore, the manager and the
investors are indifferent between a high debt and low debt
contract. In the presence of financial distress costs, the manager
has an incentive to increase his effort level in order to reduce
the threat of distress. Now investors unambiguously prefer the
(value-maximising) high debt contract. When effort costs and
financial distress costs are low, the manager also prefers the
high debt contract. When effort costs and financial distress costs
are high, the manager prefers the (value-minimising) low debt
contract. |