A Control Theory of Dynamic Capital Structure

This paper develops a model in which debt serves to constrain inefficient investments of empire building managers due to the consequent control implications of bankruptcy. Unlike related free cash flow models, capital structure is voluntarily chosen by the management, as a credible constraint which ensures sufficient efficiency to prevent takeover challenges. In particular, dynamic capital structure is derived as the optimal response of partially entrenched empire-building managers to control considerations; managers trade off empire building ambitions with the need to retain the empire to realize these ambitions. Such capital structure is dynamically consistent; in the model, managers are free to read just leverage each period. In deriving a dynamic managerial optimal capital structure, a policy of dividend payments coordinated with capital structure decisions follows naturally. Thus unlike free cash flow models, this model can explain why debt-constrained empire-building managers voluntarily choose to pay dividends and do not reverse restrictive debt imposed upon them by others. The model yields implications for debt level, frequency and term structure as a function of outside investment opportunities and the degree of managerial encroachment.