Edited by Randall S. Thomas and Jennifer G. Hill
Chapter 5: Agency Theory and Incentive Compensation
William Bratton 1 INTRODUCTION Oliver Hart shows that in an ideal (and taxless) world, first-best results can easily be achieved with an all-common-stock capital structure and a simple incentive compensation system. Hart describes a simple two-period situation where the firm is founded at t = 0 and liquidated at t = 2, with an intermediate decision respecting liquidation or continuance to be made at t = 1, along with a dividend payment. Hart would make the compensation of the manager depend entirely on the dividend d. That is, incentive compensation I should equal B(d1 + d2), where B is a proportion of the firm’s total returns. If the payment also covers liquidation proceeds, where I = B[d1 + (d2, L)], the manager can be expected to make an optimal decision respecting liquidation at t = 1. If the expected value of L at t = 1 is greater than the total returns expected at t = 2, the firm is liquidated at t = 1 and no costly contracting designed to align the manager’s incentives with those of outside investors is necessary (Hart 1995: 146–48). The problem, in Hart’s conception, is that the bribe B required to align management incentives with those of outside security holders is unfeasibly large. Accordingly, a complex capital structure must be devised in order to align incentives in the direction of optimal investment and ensure that an actor with the appropriate incentives controls the assets. Unfortunately, economic theorists have not yet managed to design that incentivecompatible capital structure, leaving us...
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