INFLUENCE COSTS AND CAPITAL STRUCTURE

This paper analyzes the role of capital structure in the presence of i ntrafirm influence activities. The hierarchical structure of large org anizations inevitably generates attempts by members to influence the d istributive consequences of organizational decisions. In corporations, for example, top management can reallocate or eliminate quasi rents e arned by their employees, while at the same time, they must rely on th ese employees to provide them with information vital to their decision making. This creates the opportunity for lower level managers to infl uence top management's discretionary decisions. As a result, divisiona l managers may attempt to inflate the corporate perception of their re lative contributions to the firm, or to take actions that make the eli mination of their rents more costly for the firm. This incentive to in fluence is especially acute when managers fear losing their jobs, for example in the event of a divestiture. Since the firm's capital struct ure can affect future divestiture decisions, it can be chosen to reduc e or increase the divisional managers' incentives to influence top man agement's decisions. The control of influence activities arises at the expense of restrictions on future divestiture decisions. Hence, there emerges an optimal capital structure that trades off the costs of inf luence activities against the costs of making poor divestiture decisio ns. The findings suggest that capital structure can also be chosen to control influence activities that arise under less extreme motivations . We identify several key factors that determine the optimal capital s tructure: the top management's prior assessment of the likelihood that it will be optimal to divest a specific division; the costs of influe nce activities to the firm and to the divisional managers; and the dif ference in the valuation of the division's assets in the current firm and under alternative uses.