Using Debt Financing to Constrain Managers

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Agency problems may arise if managers and shareholders have different objectives. Such conflicts are particularly likely when the firm's managers have too much cash at their disposal. Managers often use excess cash to finance pet projects or for perquisites such as nicer offices, corporate jets, and sky boxes at sports arenas, all of which may do little to maximize stock prices. Even worse, managers might be tempted to pay too much for an acquisition, something that could cost shareholders hundreds of millions.

13Of course, Firm N would have to make certain disclosures when it offered new shares to the public, but it might be able to meet the legal requirements without fully disclosing management's worst fears.

14Paul Asquith and David W. Mullins, Jr., "The Impact of Initiating Dividend Payments on Shareholders' Wealth," Journal of Business, January 1983, 77-96.

By contrast, managers with limited "excess cash flow" are less able to make wasteful expenditures.

Firms can reduce excess cash flow in a variety of ways. One way is to funnel some of it back to shareholders through higher dividends or stock repurchases. Another alternative is to shift the capital structure toward more debt in the hope that higher debt service requirements will force managers to be more disciplined. If debt is not serviced as required, the firm will be forced into bankruptcy, in which case its managers would likely lose their jobs. Therefore, a manager is less likely to buy an expensive new corporate jet if the firm has large debt service requirements that could cost the manager his or her job. In short, high levels of debt bond the cash flow, since much of it is pre-committed to servicing the debt.

A leveraged buyout (LBO) is one way to bond cash flow. In an LBO debt is used to finance the purchase of a company's shares, after which the firm "goes private." Many leveraged buyouts, which were especially common during the late 1980s, were designed specifically to reduce corporate waste. As noted, high debt payments force managers to conserve cash by eliminating unnecessary expenditures.

Of course, increasing debt and reducing the available cash flow has its downside: It increases the risk of bankruptcy. One professor has argued that adding debt to a firm's capital structure is like putting a dagger into the steering wheel of a car.15 The dagger— which points toward your stomach—motivates you to drive more carefully, but you may get stabbed if someone runs into you, even if you are being careful. The analogy applies to corporations in the following sense: Higher debt forces managers to be more careful with shareholders' money, but even well-run firms could face bankruptcy (get stabbed) if some event beyond their control such as a war, an earthquake, a strike, or a recession occurs. To complete the analogy, the capital structure decision comes down to deciding how big a dagger stockholders should use to keep managers in line.

Finally, too much debt may overconstrain managers. A large portion of a manager's personal wealth and reputation are tied to a single company, so managers are not well diversified. When faced with a positive NPV project that is risky, a manager may decide that it's not worth taking on the risk, even when well-diversified stockholders would find the risk acceptable. This is called the underinvestment problem. The more debt the firm has, the greater the likelihood of financial distress, and thus the greater the likelihood that managers will forego risky projects even if they have positive NPVs.

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Responses

  • Johanna
    How can debt be used to “constrain” financial managers?
    5 months ago

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