TOP-MANAGEMENT COMPENSATION AND CAPITAL STRUCTURE

The interrelationship between top-management compensation and the desi gn and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency rela tionship between shareholders and management, but also the conflicts o f interests which arise in the other contracting relationships for whi ch the firm serves as a nexus. We analyze in detail the optimal manage ment compensation for the cases when the external claims are (1) equit y 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 precommitm ent device to minimize the agency costs of debt. The optimal managemen t compensation derived has low pay-performance sensitivity. With conve rtible debt, instead of straight debt, the corresponding optimal manag erial compensation has high pay-to-performance sensitivity. A negative relationship between pay-performance sensitivity and leverage is deri ved. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy (1990) with agency theory. Other testable implicatio ns include (1) a relationship between the risk premium in corporate bo nd yields and top-management compensation structures, and (2) the anno uncement effect of adoption of executive stock option plans on bond pr ices. The model yields implications for management compensation in ban ks and Federal Deposit Insurance reform. Our results explain the dynam ics of top-management compensation in firms going through financial di stress and reorganization.