International Review of Economics and Finance 64 (2019) 586–599

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International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref

Idiosyncratic risk, managerial discretion and capital structure☆

Liu Gan a, b, Xin Xia c, *
a
School of Finance, Jiangxi University of Finance and Economics, Nanchang, China
b
Research Centre of Financial Management and Risk Prevention, Nanchang, China
c
School of Finance, Zhongnan University of Economics and Law, Wuhan, China

A R T I C L E I N F O A B S T R A C T

Keywords: This paper develops an integrated dynamic model to examine the impact of managerial
Managerial compensation compensation packages, namely, cash salary and ownership stake, and reservation income on the
Incomplete markets credit spreads and capital structure choice of a risk-averse manager who faces incomplete markets
Capital structure
and costly effort. Our model predicts an inverted U-shaped relationship between credit spreads
(market leverage) and managerial ownership stake, which reconciles empirical findings that are
inconsistent with previous theories. Moreover, in contrast to the predictions of previous models,
we find that credit spreads decrease with the manager's cash salary, whereas they increase with
the manager's reservation income. Finally, we also demonstrate that the relationship between pay-
performance sensitivity (PPS) and the firm's market leverage is dependent on the manager's
ownership stake and cash salary; this prediction provides novel empirical tests.

1. Introduction

Following the pioneering contribution of Modigliani and Miller (1958), understanding the determinants of a firm's capital structure
has become an important theme in corporate finance. Given the separation of ownership and control in typical corporations, a particular
focus of theoretical research has been the importance of self-interested managers' objectives for firms' capital structure choices (Mor-
ellec, 2004). The core of economic theory is that compensation structure has an influence on managers' objectives, thereby affecting
their financing decisions (see, e.g., Smith & Watts, 1992; John & John, 1993; Brockman Martin, and Unlu, 2010).1
In practice, managerial compensation contracts often include a cash salary, stock-based compensation (i.e., stock and stock options),
deferred compensation, earnings-based bonus compensation, and severance pay, among others. The payoff schedules of these
compensation components differ significantly. For example, the stock-based compensation is motivated as an incentive alignment
mechanism and varies with firm performance (see, e.g., Carlson & Lazrak, 2010). In contrast, the cash component of compensation
establishes a minimum pay level in all states and can provide managers with security. As a result, it is important to understand both the
effect of each component and the combined effect of the compensation structure on managers'capital structure choices. Empirically,
these issues have been explored extensively.
Several studies, such as those by Childs and Mauer (2008), Andrikopoulos (2009) and Carlson and Lazrak (2010), have begun the

☆
The authors are grateful to the two anonymous referees for their helpful comments. The research reported in this paper was supported by the
Natural Science Foundation of China (Project No. 71771107), the MOE (Ministry of Education in China) Project of Humanities and Social Sciences
(Project No. 19YJCZH032), and the Natural Science Foundation of Hunan Province of China (Project No. 2018JJ3262).
* Corresponding author.
E-mail addresses: ganliu2016@163.com (L. Gan), doublexinxiao@yeah.net (X. Xia).
1
Empirically, this has been reported by Coles, Daniel, and Naveen (2006), Lewellen (2006), and others.

https://doi.org/10.1016/j.iref.2019.08.003
Received 30 August 2017; Received in revised form 17 August 2019; Accepted 17 August 2019
Available online 19 August 2019
1059-0560/© 2019 Elsevier Inc. All rights reserved.
L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

task of theoretically linking managers' compensation structure to their financing and investment policies. The managerial compensation
package they consider has two components—a performance-insensitive component (i.e., cash salary) and a performance-sensitive
component (i.e., ownership stake). In these modelling frameworks, there is one major limitation. That is, managers are assumed to
face complete markets; then, they trade in the market for securities and can hedge business risk and act as if they were risk neutral
(Cvitani
c, Henderson, & Lazrak, 2014). However, in most situations, managers can trade in the market for securities, but the market is
incomplete because the cash flow from the firm's assets-in-place might not be spanned by existing traded financial securities (Hugonnier
& Morellec, 2007). Therefore, managers' attitudes towards risk should play a key role in determining their corporate decisions.
Taking this key friction into account, in this paper, we develop an integrated incomplete-markets model in which a single risk-averse
manager, facing non-diversifiable idiosyncratic risk, makes interdependent business decisions (leverage and default) and household
decisions (consumption-saving and portfolio choice) based on constant absolute risk aversion (CARA) utility (see Chen, Miao, & Wang,
2010; Miao & Wang, 2007). Moreover, following Cadenillas, Cvitani
c, and Zapatero (2004), He (2011) and Mu, Wang, and Yang (2017),
we assume that the firm's output dynamically depends on the manager's effort choice, which is costly. Taking the manager's decisions as
a given, outside investors (i.e., shareholders and debtholders) are assumed to face complete markets and value corporate securities
according to its market valuation. Our model provides a mapping from the manager's compensation contract, which is composed of
ownership stake and cash salary, to their optimal capital structure choice.2 In contrast to previous theories, we emphasize that our
conclusions depend directly on the ability of a manager to adjust her level of effort and her exposure to non-diversifiable idiosyncratic
risk.
Using this unified framework, our goal is to address some important gaps between already known empirical facts regarding the
observed capital structure choices for managers and to generate a rich set of novel testable predictions. Specifically, we address the
following questions: what determines the capital structure of a firm run by a risk-averse manager who is exposed to non-diversifiable
idiosyncratic risk and exerts costly effort? How does managerial compensation, namely cash salary and ownership stake, influence a
firm's market leverage, effort policy, endogenous default, credit spreads and pay-performance sensitivity (PPS)? What are the effects on
managers' reservation income?
The main findings of the paper are summarized as follows. First, we show that market leverage exhibits an inverted U-shaped
relationship with managerial ownership stake. This result differs significantly from the predictions of previous theories, but it is
consistent with the empirical evidence reported by Brailsford, Oliver, and Pua (2002). Because the market leverage varies in an inverted
U-shaped relationship, the model predicts that the credit spread exhibits an inverted U-shaped relationship with managerial ownership
stake, which is consistent with the empirical findings of Bagnani, Milonas, Saunders, and Travlos (1994).
Second, we demonstrate that the manager's cash salary has a negative effect on the level of the credit spread (market leverage),
whereas the manager's reservation income has a positive effect on the level of the credit spread (market leverage). These results
regarding the effect of the manager's cash salary and reservation income on credit spreads are opposite to those of Andrikopoulos
(2009), who assumes that managers face complete markets. Thus, we complement the aforementioned literature.
Finally, we show that the relationship between PPS and market leverage depends on the manager's ownership stake and cash salary.
When a manager has a large personal ownership stake in a firm, PPS is negatively and significantly associated with market leverage. This
result seems to be consistent with the empirical findings of Douglas (2006) and Ortiz-Molina (2007), who predict a negative relationship
between PPS and market leverage. In contrast, when a manager's ownership stake is low, PPS is positively correlated with market
leverage. Interestingly, the impact of a manager's cash salary on the relationship between PPS and market leverage is opposite to the
impact of the manager's ownership stake. As a result, we derive additional theoretical implications that link PPS to market leverage and
can provide novel empirical tests.
Related literature: Our paper belongs to a large body of literature that studies the implications of managerial discretion for firms’
investment decisions and financing policies. This literature includes Morellec (2004), Lambrecht and Myers (2008), Fu and Sub-
ramanian (2011), and Morellec, Nikolov, and Schürhoff (2012).
This paper is also closely related to the literature that explores the role of managerial compensation packages in firms' policy choices.
For example, Carpenter (2000) develops a structural model for a firm and analyses the effects of option compensation on a risk averse
manager's appetite for risk. Cadenillas et al. (2004) examine the relationship between managerial compensation and capital structure. In
their paper, stock is the only source of compensation for risk-averse managers who face costly effort. Andrikopoulos (2009) employs a
real options model to examine a risk-neutral manager's financing and investment decisions when her pay includes cash salary and
ownership stake. Carlson and Lazrak (2010) also develop a dynamic model for a firm that is run by a risk-averse manager whose
compensation is composed of cash salary and stock. Moreover, managers control the variance of cash flows, and their preferences are
assumed to exhibit constant relative risk aversion (CRRA). In this modelling framework, they aim to theoretically link compensation
structure, credit spreads, and market leverage. The previous research, however, has mainly relied on the assumption that managers face
complete markets. In this paper, we show that incorporating incomplete markets frictions in models leads to a richer set of empirical
predictions and helps explain corporate behaviour.
He (2011) embeds optimal contracting between shareholders and the manager into the classical capital structure model (e.g., Leland,
1994). He then provides a general framework to analyse the interaction between agency characteristics and debt-overhang. In contrast,
we restrict the compensation contract structure to commonly observed forms, as presented in Carlson and Lazrak (2010).
On a methodological level, our paper relates to the growing literature regarding the dynamic incomplete-markets model. Hugonnier
and Morellec (2007) employ the standard real options approach to study the effects of managerial risk aversion on firm value and

2
Both of these components are rationalized in the standard principal-agent framework (see, e.g., H€
omstrom, 1979).

587
L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

investment decisions when managers face incomplete markets and have control rights over investment policy. Miao and Wang (2007)
develop a dynamic model of real investment for a risk-averse entrepreneur who is exposed to non-diversifiable idiosyncratic risk. Chen
et al. (2010) develop a dynamic incomplete-markets model where a risk-averse entrepreneur decides the firm's capital structure, in
addition to making portfolio and consumption decisions. Further, Wang, Wang, and Yang (2012) analyse a risk-averse entrepreneur's
optimal consumption, capital accumulation, portfolio choice, and business exit decisions in a q-theoretic model with liquidity con-
straints and non-diversifiable risk. These papers, however, do not study the implications of managerial compensation in publicly traded
firms and do not model the managerial moral hazard problem that arises from unobserved effort policy.

2. The model

This paper investigates the capital structure choices of risk-averse managers in publicly traded firms within the framework of a
dynamic model. In the model, we follow Hugonnier and Morellec (2007) to assume that outside investors (i.e., shareholders and
debtholders) have access to a perfectly competitive and complete financial market and thus are well diversified, whereas managers face
incomplete markets and cannot completely hedge business risk. Moreover, similar to Cadenillas et al. (2004), He (2011) and Mu et al.
(2017), a moral hazard problem is introduced by assuming that the manager's costly effort is unobservable to shareholders. We consider
an infinite horizon model of a continuous-time economy. The risk-free rate is r.

2.1. Setup

Consider a setting in which well-diversified shareholders (the principal) employ a single manager who is risk-averse to operate the
firm. In combination with the moral hazard of the manager, the firm's assets-in-place generates stochastic revenue yt at a constant
operating cost F per unit time, where yt is governed by the following geometric Brownian motion under a physical probability measure
(Chen et al., 2010)P:

dyt pffiffiffiffiffiffiffiffiffiffiffiffiffi
¼ μðat Þdt þ ρσ dBt þ 1  ρ2 σ dZt ; t  0: (1)
yt
Here, the manager can exert unobservable effort at 2 ½0; 1 to control the cash flow growth rate μðat Þ, where μ'ðat Þ > 0, and μ''ðat Þ 
0.3 In what follows, for simplicity, we choose the following widely used function of μðat Þ (e.g., Mu et al., 2017):

μðat Þ ¼ υat ; (2)

where υ > 0 is a constant parameter that satisfies r > υ for convergence. The parameter σ > 0 is the total volatility of cash flow growth.
All sources of uncertainty arise from two independent components defined on a physical probability space ðΩ; F ; fF t gt0 ; PÞ: the
standard Brownian motion B provides the sources of market (systematic) risks, and the standard Brownian motion Z provides the sources
of idiosyncratic risks. The constant ρ 2 ½ 1; 1 is the correlation coefficient between the firm's cash flow risk and market risk. The
pffiffiffiffiffiffiffiffiffiffiffiffiffiffi
systematic volatility of cash flow growth is ξ ¼ ρσ and the idiosyncratic volatility satisfies ε ¼ 1  ρ2 σ .

2.2. Managerial compensation

Following Andrikopoulos (2009) and Carlson and Lazrak (2010), we define a realistic yet simple managerial compensation contract
by a vector ðϕ;mÞ, where ϕ 2 ½0; 1 is the number of shares owned by the manager (expressed as a fraction of the firm's total equity), m 
0 is the fixed cash salary collected per unit of time.4 The ownership compensation is sensitive to firm performance, whereas the cash
salary is performance-insensitive pay. We do not consider stock options as a component of managerial compensation. We make this
choice for two reasons: (i) many corporations now use stock exclusively instead of a combination of stocks and options to incentivize
managers; and (ii) a linear contract is a good approximation for nonlinear contracts, e.g., as presented by Jin (2002).
Note that the manager's cash salary is a part of the constant operating cost; thus, it could directly affect the firm's operating leverage.
Moreover, as shown by Simintzi, Vig, and Volpin (2014), an interesting aspect of operating leverage is that it has the potential to crowd
out financial leverage. As a result, in contrast to the modelling approaches of Andrikopoulos (2009) and Carlson and Lazrak (2010), to
further highlight the effects of cash salary m on the firm's optimal leverage, we assume that the operating cost is given by F ¼ f þ m,
where f is the fixed cost parameter.
In addition, it is difficult to verify and base contracts on decisions such as capital structure, since they often involve managerial
discretion (Morellec, 2004). Following previous research (e.g., Andrikopoulos, 2009), this paper does not take a stand regarding the
optimality of the contracts but instead takes compensation contracts (both cash salary and ownership stake) as a given. Our goal is to
understand how the observed compensation contracts shape the manager's choice of capital structure.

3
μ'ðat Þ > 0 means that hard-working managers make the firm more profitable, whereas μ''ðat Þ  0 measures the decreasing marginal effect of effort
(see Mu et al., 2017).
4
This assumption is also consistent with other work regarding managerial compensation contracts; see, for example, H€ olmstrom and Milgrom
(1987), H€ olmstrom and Milgrom (1991), and Morellec (2004).

588
L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

2.3. Debt financing and default

Firms pay taxes based on their cash flows from operations at a rate τ > 0. Therefore, to shield profits from taxation, the firm has an
incentive to issue debt at the initial time t ¼ 0. As in Leland (1994) and numerous other capital structure models, we consider
infinite-maturity debt contracts. At each moment in time, the coupon payment of debt is b. After risky debt has been issued, at any time
t > 0, firms may default on the outstanding debt when their conditions deteriorate sufficiently. We assume that absolute priority is
enforced and do not consider any ex post renegotiation between the outside debt holders and the manager in bankruptcy proceedings.
Moreover, at the time of default T d , the outside debt holders liquidate the firm immediately, and a fraction α ð0 < α  1Þ of assets are
lost as bankruptcy costs.
Should the firm go bankrupt, the manager loses her equity compensation and fixed cash salary, but she can take an alternative job
(e.g., be a manager in another firm) to accrue financial wealth (Andrikopoulos, 2009). We assume that the alternative job gives the
manager a constant flow of reservation income at rate rΠ, which has present value Π. However, bankruptcy is also personally costly to
the manager (Eckbo, Thorburn, & Wang, 2016). We naturally assume that the manager's current position potentially offers a higher
income than the alternative job after bankruptcy. Thus, the reservation income Π can be a measure of the manager's loss of compen-
sation in bankruptcy. A smaller Π implies that the manager's loss of compensation in bankruptcy is larger. As we will show, in our model,
Π plays an important role in managers' corporate decisions. Finally, we follow the large body of literature that studies the implications of
managerial discretion (e.g., Andrikopoulos, 2009; Carlson & Lazrak, 2010; Childs & Mauer, 2008) by assuming that managers are not
able to recover their salary in bankruptcy so that the model can best highlight the central economic mechanism arising from incomplete
markets.5
The agency costs of managerial discretion depend on the allocation of control rights within the firm. We follow Morellec (2004),
Lambrecht and Myers (2008) and Morellec et al. (2012) by assuming that a manager has decision rights over the firm's financing
policies, i.e., capital structure and default decisions. Moreover, managers' policy choices maximize the utility that they will obtain from
the firm.

2.4. Financial investment opportunities

Given that the firm's cash flow is subject to both systematic and idiosyncratic shocks, we follow Hugonnier and Morellec (2007) and
Bolton, Wang, and Yang (2019) to assume that unconstrained investors can dynamically complete financial markets by the continuous
trading of three non-redundant financial securities. The first financial security available for unconstrained investors to trade is the
risk-free asset that pays interest at a rate of r. The remaining two financial securities are risky assets. Specifically, the first risky security is
perfectly correlated with the idiosyncratic risk generated by the Brownian motion Z. The second risky security is a (stock) market
portfolio, which is subject to the systematic shock B. The incremental return dRt of the market portfolio over time period dt is (see, e.g.,
Chen et al., 2010; Bolton et al., 2019)

dRt ¼ μR dt þ σ R dBt ; (3)

where μR and σ R > 0 are the mean and volatility parameters, respectively. The Sharpe ratio of the market portfolio (denoted by η) is
defined as
μR  r
η¼ : (4)
σR
Following Hugonnier and Morellec (2007), we assume that outside investors can dynamically complete financial markets with the
above three non-redundant financial securities. Thus, they are well diversified and only require a risk premium for their exposures to
systematic risks. By contrast, managers are assumed to be allowed to trade only in the risk-free security and the risky market portfolio. In
such circumstances, the manager is able to hedge her portfolio of outstanding equity incentives, as discussed in Gao (2010). However,
she faces incomplete markets and cannot diversify her idiosyncratic risk exposure because the cash flow from the firm's assets-in-place is
not spanned by existing traded financial securities (Hugonnier & Morellec, 2007). As a result, the manager demands both systematic and
idiosyncratic risk premiums.

2.5. The manager's liquid wealth dynamics

Let fwt : t  0g denote the manager's liquid (financial) wealth at time t. Prior to bankruptcy, the manager's liquid financial wealth w
evolves as follows:

dwt ¼ ½rwt þ ϕð1  τÞðyt  f  m  bÞ þ m  ct dt þ π t ððμR  rÞdt þ σ R dBt Þ; 0 < t < T d ; (5)

where π t is the amount of wealth invested in the risky market portfolio, and thus, ðwt  π t Þ is the remaining amount invested in the risk-
free security. The first term in Equation (5) represents the liquid wealth accumulation when the manager is fully invested in the risk-free

5
That is, we do not consider a manager's protected salary in the case of default. Ellul and Pagano (2017) provides a discussion on this point.

589
L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

security plus the compensation package for running the firm (i.e., ownership shares ϕð1  τÞðyt  f  m  bÞ and her fixed salary m)
minus consumption c. The second term in Equation (5) represents the excess return on the risky market portfolio.
After bankruptcy, the manager collects her reservation income and accumulates financial wealth. Then, her wealth accumulation is
given by

dwt ¼ ðrwt þ rΠ  ct Þdt þ π t ððμR  rÞdt þ σ R dBt Þ; t > T d : (6)

2.6. The manager's problem

The manager is characterized by her risk preference UðÞ and a subjective discount rate ζ. Her objective is to choose financial
portfolio π t , consumption ct , effort policy at , bond coupon b and default timing T d to maximize her lifetime utility:
Z ∞ 
max E eζt Uðct ; at Þdt ; (7)
c;π ;a;b;T d 0

taking the form of her compensation contract as given. For tractability, we adopt the constant absolute risk-averse (CARA) utility (see,
e.g., Miao & Wang, 2007; Chen et al., 2010; He, 2011):

1
Uðct ; at Þ ¼  eγðct gðat ;yt ÞÞ ; (8)
γ

where γ > 0 is the coefficient of absolute risk aversion and gða; yÞ is the manager's cost of effort in units of consumption, with
∂gða; yÞ =∂a > 0 and ∂2 gða; yÞ =∂a2  0. Following He (2011), we assume that gða; yÞ is given by:

θ
gðat ; yt Þ ¼ a2t yt ; (9)
2

where θ is a constant parameter.

3. Model solution

In this section, we rely on the dynamic programming method to characterize the model solution. Specifically, we first present the
manager's joint portfolio allocation, consumption, effort policy and default decisions. Then, we report the market values of equity and
debt from the perspective of the outside investors, who face complete markets. Finally, we solve the manager's initial (time-0) capital
structure choice, considering her future decisions.

3.1. Manager's decisions and certainty-equivalent valuation

Similar to Chen et al. (2010), to solve the manager's problem, we proceed in two steps. First, we solve the standard Merton portfolio
and consumption choice problem faced by the manager after bankruptcy. Second, we solve the manager's optimization problem during
the operating stage.
After bankruptcy (t > T d ), the manager collects a reservation income, allocates wealth between the risky market portfolio and the
risk-free security, and consumes. In such situations, the manager's optimization problem is equivalent to the classical Merton problem
studied in Merton (1971). Thus, we can directly write the post-bankruptcy value function VðwÞ as (see, e.g., Miao & Wang, 2007; Chen
et al., 2010)
  
1 η2 ζr
VðwÞ ¼  exp  γr w þ Π þ þ : (10)
γr 2γr2 γr2
Prior to bankruptcy, we follow Chen et al. (2010) to conjecture that the manager's value function Jðw; yÞ takes the following form:
  
1 η2 ζr
Jðw; yÞ ¼  exp  γr w þ MðyÞ þ þ ; (11)
γr 2γr2 γr 2

where MðyÞ is the certainty-equivalent valuation of the manager's payoff. We then summarize the solution for MðyÞ and the manager's
decision rules in the following proposition (the proof is given in Appendix).
Proposition 1. Before bankruptcy, the manager's certainty-equivalent valuation of her payoff, MðyÞ, satisfies the following ordinary differ-
ential equation (ODE):

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L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

θ
rMðyÞ ¼ ϕð1  τÞðy  f  m  bÞ þ m  ða Þ2 y þ ðυa  ρσηÞyM'ðyÞþ
2
(12)
ðσ yÞ2 γrε2 y2
M''ðyÞ  M'ðyÞ2 :
2 2
We solve the ODE (12) subject to the standard no-bubble condition limy→∞ MðyÞ
y
< ∞ and the following (free) boundary conditions:

Mðyd Þ ¼ Π; (13)

M'ðyd Þ ¼ 0; (14)

where yd is the default threshold selected by the manager. The optimal effort policy a is
 
υM'ðyÞ
a ðyÞ ¼ min ;1 : (15)
θ
The manager’s consumption rule is

θ η2 ζ  r
cðw; yÞ ¼ ða Þ2 y þ rw þ þ þ rMðyÞ: (16)
2 2γr γr
The manager’s risky market portfolio rule is
η ρσ y
π ðw; yÞ ¼  M'ðyÞ: (17)
γrσ R σR
The last term in Equation (12) captures the idiosyncratic risk effect. Equation (13) is the value-matching condition for the manager’s
default decision. The smooth-pasting condition (14) arises from the fact that the manager optimally chooses the default threshold. The
optimal effort policy (15) is determined by the manager’s marginal value M'ðyÞ. Both the consumption rule (16) and the portfolio rule
(17) are similar to other CARA-utility based precautionary-saving models (e.g., Miao & Wang, 2007; Chen, Miao and Wang,2010).

3.2. The market values of equity and debt

We now characterize the market values of equity and debt for a given capital structure. Unlike the manager, the outside investors are
assumed to face complete markets. Then, the implied unique pricing kernel fMt : t  0g is given by dMt ¼  rMt dt  ηMt dBt , with
M0 ¼ 1 (see, e.g., Chen, Wang, and Miao, 2010; Duffie, 2010). Let Q be a risk-neutral probability measure equivalent to the physical
dP jF t ¼ expðrtÞMt (the Radon-Nikodym derivative). Under Q, the dynamics of the revenue in (1) can be
measure P that satisfies dQ
rewritten as

dyt pffiffiffiffiffiffiffiffiffiffiffiffiffi
¼ νðat Þdt þ ρσ dBQ
t þ 1  ρ2 σ dZt ; (18)
yt

where the risk-adjusted expected growth rate νðat Þ is given by νðat Þ ¼ μðat Þ  ρση, and BQt is a standard Brownian motion under a
measure Q that satisfies dBQ t ¼ dBt þ ηdt.
Let EðyÞ denote the market value of the firm's total (inside and outside) equity. Prior to bankruptcy, shareholders receive cash flow
ð1  τÞðyt  f  m  bÞ at each time t. When bankruptcy occurs, they obtain nothing owing to the absolute priority rule. As a result, the
market value of total equity, EðyÞ, is given by
"Z #
Td
EðyÞ ¼ EQ
t erðstÞ ð1  τÞðys  f  m  bÞds ; (19)
t

where EQ
t ½  is the time-t conditional expectation under Q. According to dynamic programming, we are led to the following proposition.

Proposition 2. For a given capital structure, the market value of equity EðyÞ satisfies the following ODE:

1
rEðyÞ ¼ ð1  τÞðy  f  m  bÞ þ νða ÞyE'ðyÞ þ σ 2 y2 E''ðyÞ; (20)
2

where a is given in (15). We solve the ODE (20) subject to the following value-matching condition:

Eðyd Þ ¼ 0; (21)

and the standard no-bubble condition:

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L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

EðyÞ
lim < ∞: (22)
y→∞ y
Regarding the market value of debt, when the firm goes bankrupt, debtholders take control of the firm and become the sole owner
(Leland, 1994). Therefore, there are no agency frictions in the firm. Following Chen et al. (2010), the liquidation value of the firm is
assumed to be equal to a fraction ð1  αÞ of the market value of an unlevered public firm absent frictions, AðyÞ (shown in
Appendix (A.2)). The market value of debt, DðyÞ, is defined as the present value of coupon payments before bankruptcy plus total
recoveries at the time of default T d :
"Z #
Td
erðstÞ bds þ erðT Þ ð1  αÞAðy Þ :
d t
DðyÞ ¼ EQ
t d (23)
t

We can summarize the results as follows.

Proposition 3. For a given capital structure, the market value of debt DðyÞ satisfies the following ODE:

1
rDðyÞ ¼ b þ νða ÞyD'ðyÞ þ σ 2 y2 D''ðyÞ: (24)
2
We solve the ODE (24) subject to the value-matching condition

Dðyd Þ ¼ ð1  αÞAðyd Þ; (25)

and the usual no-bubble condition,

b
lim DðyÞ ¼ : (26)
y→∞ r
The market value of the leveraged firm is equal to the sum of its equity value and its debt value:

FðyÞ ¼ EðyÞ þ DðyÞ: (27)

For a given coupon b, the natural measure of market leverage from the outside investors’ point of view is the ratio between the market value of
debt and the market value of the firm:

Dðy; bÞ
LRðy; bÞ ¼ : (28)
Fðy; bÞ

3.3. The manager's capital structure choice

We now turn to the manager's optimal capital structure choice at the initial time t ¼ 0 (the time of debt issuance). In our model, an
undiversified manager's privately optimal financing structure is determined by balancing the benefits of market debt, which include the
diversification benefits and the tax deductibility of payments to debtholders (Chen et al., 2010), with their costs, which include default
costs and loss of future earnings. We assume that the debt is fairly priced at time 0. Therefore, given time 0 and cash flow level y0 , the ex
ante value of the manager's total payoff, Gðy0 ; bÞ, is defined as

Gðy0 ; bÞ ¼ Mðy0 ; bÞ þ ϕDðy0 ; bÞ; (29)

because the manager is rewarded with a fraction ϕ of the firm's total equity. When making capital structure decisions, the objective of
the manager is therefore to select the coupon level b that maximizes the ex ante value of her total payoff. That is, the manager solves

b ðy0 Þ ¼ argmaxGðy0 ; bÞ: (30)

b

The optimal coupon on market debt cannot be obtained analytically. In the next section, we circumvent this difficulty by solving
numerically the capital structure choice of the manager.

4. Model implications

In this section, we discuss the manager's effort policy and the effect of the managerial compensation package (i.e., cash salary and
ownership stake) and reservation income on debt credit spreads and capital structure. We also analyse our baseline model's implications
regarding PPS.

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4.1. Parameter calibration

Our parameter choices are summarized in Table 1. Panel A shows the economy and firm characteristics. The risk-free rate is set equal
to r ¼ 3%, which is very close to the mean of the risk-free rate calibrated by Arnold, Wagner, and Westermann (2013). The market price
of risk is set to η ¼ 40%, in line with the calibration in Chen (2010). Following Morellec (2004), we set the effective tax rate on business
profits at τ ¼ 15%. We set the growth rate parameter of the cash flow shock to υ ¼ 2%, the systematic volatility of the growth rate to ξ ¼
10%, the idiosyncratic volatility to ε ¼ 20%. These are standard parameter values in the corporate finance literature (e.g., Chen, 2010).
Glover (2016) estimates the direct costs of bankruptcy to average 45% of firm value. Therefore, we choose α ¼ 45%. As for the fixed
operating cost parameter, we choose f ¼ 0:5 based on empirical estimates reported in Chen, Harford, and Kamara (2019). There is no
direct empirical evidence on the effort cost parameter, we carefully choose θ ¼ 0:01 so that in our parameterization, the optimal effort
fa g never binds at the upper-bound effort 1. Without loss of generality, the initial value of the cash flow shock is set equal to y0 ¼ 1
(normalized).
For managerial compensation- and preferences-related parameters (shown in Panel B), the single manager's ownership proportion is
taken to be ϕ ¼ 2:8%, which is within the range of the sample analysed by Edmans, Gabaix, and Jenter (2017) for S&P firms. The cash
salary is set at m ¼ 0:01. In the benchmark model, this value implies that the cash salary to operating cost ratio is around 2%. This is in
the normal range of the cash salary to operating cost ratio from Execucomp during the period of 2008-2017. We calibrate the reservation
income Π to match the manager's loss rate of compensation in bankruptcy documented in the empirical literature. In the full sample of
Eckbo et al. (2016), the sample mean of the loss rate of managerial compensation in bankruptcy is approximately 26%, which yields Π ¼
0:3. Finally, we set the manager's coefficient of absolute risk aversion to be γ ¼ 1 based on estimates reported in Gayle and Miller
(2009).

4.2. Optimal effort

Taking compensation structure as given, consider first the optimal effort policy of an undiversified manager. Intuitively, the man-
ager's effort choice reflects a trade-off between the extra return benefits and the cost of the effort. Recall that because the level of the
manager's effort affects the firm's growth rate directly, an important question arises: What is the optimal effort that the manager should
devote to running the firm?
Panel a of Fig. 1 presents the relationship between the optimal initial effort at the initial time, a ðy0 Þ, and the market leverage ratio
for various values of risk aversion γ. The figure shows that given any market leverage ratio, a more risk-averse manager will expend less
effort. For instance, for a plausible market leverage of 30%, as we increase γ from 1 to 3, the manager's effort level decreases by 2:2%,
from 0.545 to 0.533, and the market value of equity decreases by 0:98%, from 4.298 to 4.256. Intuitively, higher risk aversion raises the
idiosyncratic risk premium that the manager requires for running the firm and thus lowers the effort level. Panel a of Fig. 1 also il-
lustrates that for each level of risk aversion, increasing the leverage ratio has a negative impact on the manager's effort policy and, thus, a
negative impact on the profitability of the firm (i.e., cash flow growth rate). The reason for this result is that given the manager's
compensation package, the existing debt discourages the manager, who is paid in equity, from exerting high effort because part of the
value increase from this effort accrues to existing debtholders, owing to the debt priority and seniority structure. This is a debt overhang
problem, as first presented in Myers (1977), when we interpret the manager's effort as a form of investment (see, e.g., He, 2011).
Furthermore, there is an inverse relationship between profitability and market leverage that is frequently found in the empirical
literature (e.g., Myers, 1993).
Panel b of Fig. 1 plots the manager's dynamic effort policy a ðyÞ as a function of cash flow y. As expected, when γ approaches 0 (i.e.,
the manager becomes risk neutral), the manager's effort level increases with cash flow y. By contrast, the above result no longer holds

Table 1
Baseline parameter values.
Symbol Description Value

Panel A Economy and Firm Characteristics

r The risk-free rate 3%
η The market price of risk 40%
τ The effective tax rate 15%
υ The growth rate parameter 2%
ξ The systematic volatility 10%
ε The idiosyncratic volatility 20%
α The bankruptcy loss rate 45%
f The fixed operating cost 0.5
θ The effort cost 0.01
y0 The initial value of the cash flow 1
Panel B Managerial Compensation and Preferences
ϕ The single manager's ownership proportion 2.8%
m The cash salary 0.01
Π The reservation income 0.3
γ The manager's coefficient of absolute risk aversion 1

This table summarizes the baseline parameter values, which are annualized when applicable.

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Fig. 1. The figure presents the manager's optimal effort policy with respect to the market leverage ratio and revenue y for three different levels of
risk aversion.

when risk aversion γ > 0. That is, for γ > 0, a nonmonotonic relation between the manager's effort policy a ðyÞ and cash flow y should
prevail. The reason is that in such situations, the manager has a precautionary saving demand to partially diversify the idiosyncratic risk
(see Chen, Wang, and Miao, 2010). Specifically, for low values of y, the precautionary savings effect is small because low idiosyncratic
risk exposure, and thus, a ðyÞ increases with y. For sufficiently high values of y, the manager has a strong precautionary saving incentive
to reduce her idiosyncratic risk exposure. Therefore, the strong precautionary saving effect leads managers to decrease effort a ðyÞ with
y for high y.

4.3. The effects of managerial compensation on credit spreads and capital structure

We now turn to the impact of the manager's compensation package on credit spreads and her choice of capital structure.
Ownership stake. From Panel a of Fig. 2, we see that the relation between the optimal coupon payment and the manager's ownership
stake exhibits an inverted U-pattern, and there is thus an inverted U-pattern relationship between market leverage and the manager's
ownership stake (see Panel b of Fig. 2). This result differs significantly from the theoretical predictions of Andrikopoulos (2009), who
report that a risk-neutral manager's ownership stake has a negative effect on market leverage. The reason for this difference is that in our
model, managers who cannot fully diversify their idiosyncratic risk trade off two opposing effects when selecting the firm's debt policy. On
the one hand, managers prefer greater debt financing to harvest the tax shield and diversification benefits (see, e.g., Chen et al., 2010). On
the other hand, the managers have disincentives to issue debt because debt results in the possibility of bankruptcy, with the associated loss
of expected future wealth for the manager (in particular, more debt leads to a lower level of effort because of debt overhang). At
low-ownership shares, the value of the manager's stock compensation is low; thus, the first effect dominates, and the market leverage
increases with stock ownership. In contrast, when the stock compensation is sufficiently large, the second effect dominates, and thus, the
market leverage decreases with managerial ownership stake. Our result is consistent with the empirical findings reported by Brailsford
et al. (2002), who document an inverted U-shaped relationship between market leverage and managerial ownership stake.
Panel c of Fig. 2 shows that the default threshold exhibits an inverted U-shaped relationship with the managerial ownership stake ϕ.
This relationship holds for the same reason that the market leverage ratio varies in an inverted U-shaped manner. Because the default
threshold varies in an inverted U-shaped manner, our model predicts that credit spreads also vary in an inverted U-shaped manner with
the managerial ownership stake. This result is in accordance with the empirical findings of Bagnani et al. (1994). Moreover, Anderson,
Mansi, and Reeb (2002) also find that having a manager with sufficiently high ownership stake predicts low credit spreads.
Overall, Fig. 2 shows that given any ownership compensation, increasing the manager's risk aversion γ elevates the debt level, default
boundary, and credit spread. These properties are consistent with related studies (see, e.g., Chen et al., 2010) involving non-diversifiable
idiosyncratic risk. Thus, we conclude that the above results are robust.
Cash salary. Having examined the impact of the managerial ownership stake on credit spreads and capital structure, we proceed to
explore the effect of the manager's cash salary. Table 2 summarizes the main results. As can be seen in the second column of Table 2, an
increase in cash salary m results in a higher level of effort. This result might go against some of the literature. The reason is that, on the
one hand, in our modelling framework, following the large body of literature that studies the implications of managerial discretion (e.g.,
Childs & Mauer, 2008; Andrikopoulos, 2009; Carlson & Lazrak, 2010; Fu & Subramanian, 2011; and; Morellec, Nikolov and Schurhoff,
2012), compensation incentives are the only factor affecting managers' effort decisions. However, in practice, firms can motivate
managers through compensation, supervision, leisure time and other means. Some previous studies have considered these incentives,
and thus, the overall effect of cash salary on the manager's effort exhibits different behaviour from that in our paper (e.g., an inverted
U-shaped relationship). On the other hand, because bankruptcy is personally costly to the manager in this paper, the reservation income
does not give the manager an incentive to default. As a result, cash salary provides the manager with incentives to exert effort due to she
is exposed to bankruptcy risk.

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L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

Fig. 2. The figure illustrates the effect of manager's ownership stake on the coupon payment, market leverage, default threshold and credit spreads of
 

debt for different levels of risk aversion. Credit spreads of debt (in basis points) are defined as CSðy0 Þ ¼ Dðyb0 ;bðy0ðyÞ 0 ÞÞ  r  10; 000.

Table 2
Comparative statics.
a ðy0 Þ b ðy0 Þ yd LRðy0 Þ CSðy0 Þ

Base case 0.483 0.275 0.484 48.68% 625

m¼0.0050 0.235 0.501 0.751 75.11% 959
m¼0.0075 0.354 0.405 0.625 64.14% 800
m¼0.0125 0.594 0.151 0.328 31.90% 450
m¼0.0150 0.660 0.095 0.234 21.85% 426

This table reports the impact of cash salary on the risk-averse manager's capital structure choice.

In addition, since the cash component of compensation provides the risk-averse manager with security, an increased cash salary will
also make the manager want to keep the firm alive for as long as possible to maintain the fixed income flow. Thus, to decrease the
probability of bankruptcy, the optimal coupon payment and the market leverage ratio decrease with an increasing cash salary (see the
third and fifth columns of Table 2). Associated with the manager's motive to issue low levels of market debt, our model predicts that the
effect of the manager's salary on the default policy is negative, and thus, the credit spreads of debt strongly decrease as salary increases
(see the sixth column of Table 2). This predicted result is in sharp contrast with the predictions of the previous models presented in
Andrikopoulos (2009), who ignored the manager's non-diversifiable idiosyncratic risk and endogenous effort choice and reported a
positive relationship between credits spreads and cash salary. Therefore, our result for the effect of manager's cash salary on credit
spreads and capital structure extends and complements the discussion in Andrikopoulos (2009).

4.4. Pay-performance sensitivity

Empirically, the relationship between the manager's PPS and market leverage ratios has received considerable attention. To this end,
we now impose some structure on our model to study the pattern of relationships between PPS and market leverage ratios. In the current

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Fig. 3. The figure illustrates the dependence of PPS on the market leverage ratio for different compensation packages.

continuous-time model framework (e.g., He, 2011), the literature generally uses the response of the manager's wealth to a unit shock to
the market value of equity as a measure of PPS (i.e., the dollar-to-dollar measure). Following this definition, we can derive the manager's
PPS in this model, in that

dMðyÞ dMðyÞ=dy
PPSðyÞ ¼ ¼ : (31)
dEðyÞ dEðyÞ=dy
Intuitively, the result of Equation (31) implies that the manager's PPS depends on the compensation structure. In the previous ex-
ecutive compensation literature, for linear contracts, the PPS and managerial ownership ϕ are economically the same because both
shareholders and managers face complete markets.6 However, by introducing incomplete-market frictions, the PPS in our model
measures the certainty-equivalent (private) value change (in dollars) of the manager's payoff associated with the change (in dollars) in
the market value of equity.
Fig. 3 presents the relationship between PPS and market leverage ratios for different managerial compensation packages. It is clear
that given any leverage ratio, increasing the manager's ownership stake ϕ or salary m elevates PPS, since the value of the managerial
wealth increases. PPS is generally positively related to managerial ownership stake, which provides support for the empirical findings of
Hall and Liebman (1998), who document a positive relationship between managerial ownership stake and PPS. Thus, our model offers a
theoretical basis for this stylized fact. By contrast, a central prediction of the empirical literature is that PPS is negatively correlated with
firm leverage (see, e.g., John & John, 1993; Douglas, 2006; Ortiz-Molina, 2007). However, our model predicts that the relationship
between PPS and leverage ratios depends on the manager's ownership stake and cash salary. To be more specific, when the manager is
paid a large personal equity stake in the firm, PPS is negatively and significantly associated with firm leverage. In contrast, when the
manager's ownership stake is relatively small, the relationship between PPS and leverage ratios becomes positive. Interestingly, in
contrast with the impact of ownership stake ϕ, when the manager's salary is low, the PPS decreases with the market leverage ratio,
whereas when the salary is high, PPS is an increasing function of the market leverage ratio. As a result, these findings provide novel
empirical tests for the relationship between firm leverage and PPS.

4.5. Comparative statics

In this subsection, we provide the comparative statics results regarding the impact of the manager-specific parameter (her reser-
vation income Π) and the firm-specific parameter (the idiosyncratic volatility ε) on the manager's effort policy, the credit spread, the
capital structure, and PPS. Table 3 summarizes the main results.
Reservation income. The effect of the reservation income (see Panel A) on the manager's debt policy stems from the impact of the
reservation income on effort level and the default choice. As we have discussed, the manager's reservation income measures her loss of
compensation in default. Thus, not surprisingly, the larger the value of the reservation income is, the less attractive it is for the manager
to work hard. Therefore, as Π increases, the manager exerts less effort, yielding a lower revenue growth rate and firm value.
Furthermore, as in Andrikopoulos (2009), an increase in reservation income lowers the manager's equity-driven incentive, and this
effect induces the manager's motive to default early. Thus, these conditions lead the manager to increase the level of the optimal coupon
payment and the market leverage ratio as the reservation income increases. Associated with the manager's motive to choose a high debt
level, the relationship between the reservation income and the credit spreads is positive. This predicted result is opposite to the pre-
dictions of previous models, e.g., that of Andrikopoulos (2009). In addition, because the additional benefits from the reservation income
(the manager provides diminishing effort) will decrease the managerial compensation value, we find that PPS is a decreasing function of

6
Empirically, the dollar-to-dollar PPS of Jensen and Murphy (1990) can be a proxy for managerial fractional ownership.

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L. Gan, X. Xia International Review of Economics and Finance 64 (2019) 586–599

Table 3
Comparative statics.
a ðy0 Þ b ðy0 Þ yd LRðy0 Þ CSðy0 Þ PPSðy0 Þ

Base case 0.483 0.275 0.484 48.68% 625 2.47%

Panel A
Π¼0.00 0.721 0.085 0.113 31.81% 179 2.83%
Π¼0.15 0.636 0.145 0.273 32.53% 380 2.77%
Π¼0.45 0.263 0.475 0.719 72.10% 990 1.78%
Π¼0.60 0.011 0.675 0.984 98.21% 1312 0.12%
Panel B
ε¼0.10 0.460 0.211 0.547 52.22% 537 2.55%
ε¼0.15 0.467 0.249 0.531 51.69% 587 2.51%
ε¼0.25 0.490 0.312 0.453 46.90% 689 2.44%
ε¼0.30 0.495 0.354 0.422 45.69% 763 2.40%

This table reports the comparative statics results for the impact of the reservation income and the idiosyncratic volatility on the manager's effort policy,
capital structure choice, and PPS.

the reservation income Π. To the best of our knowledge, no previous research has associated the manager's income from alternative
employment opportunities with PPS in a dynamic financing setting.
Idiosyncratic volatility. We now turn to the impact of idiosyncratic volatility (shown in Panel B of Table 3). A higher ε means more
uncertainty in cash flows and, consequently, in the compensation value, thus reducing the manager's motivation to work hard (i.e., the
effort level). If we follow He (2011) to interpret the manager's effort as a form of firm investment, this prediction is consistent with
Panousi and Papanikolaou (2012), who find that the investment level of a firm controlled by a risk-averse manager decreases as the
firm's idiosyncratic risk rises. In addition, a risk-averse manager chooses to issue more debt for the firm because market debt helps
reduce her idiosyncratic risk exposure (see Chen et al., 2010). Thus, both the coupon and market leverage become monotonically
increasing in ε, consistent with the theoretical results reported by Chen et al. (2010). Finally, we find that PPS decreases with an
increasing (idiosyncratic) volatility (firm risk). This result is consistent with the broad empirical evidence regarding the relationship
between PPS and firm risk (volatility) (see, e.g., Aggarwal & Samwick, 1999; Jin, 2002; and Garvey & Milbourn, 2003).

5. Conclusion

The corporate finance literature has long stressed the importance of compensation packages in determining managers' financing
choices under complete markets. However, managers often face incomplete markets because the cash flow from the firm's assets-in-place
might not be spanned by existing traded financial securities (Hugonnier & Morellec, 2007). In this paper, we develop a dynamic
incomplete-markets model where a risk-averse manager makes interdependent decisions regarding effort, financing, default,
consumption-savings, and portfolio choice. We primarily focus on investigating how compensation packages (i.e., cash and ownership
stake) and reservation income affect a manager's effort policy, credit spreads, capital structure, and PPS under such circumstances.
As shown in the paper, our results can help reconcile several empirical findings that are not completely consistent with previous
theories and generate a rich set of novel empirical tests. Specifically, consistent with the empirical evidence, credit spreads (market
leverage) vary in a U-shaped manner with the managerial ownership stake. Credit spreads decline with managerial salary, whereas they
increase with the manager's reservation income. This result is opposite to the predictions of previous theories. The relationship between
PPS and market leverage ratios is dependent on the managerial compensation structure. This result can be further examined in the future.
In this paper, managerial compensation contracts only consider a performance-insensitive component (i.e., cash salary) and a
performance-sensitive component (i.e., ownership stake), ignoring inside debt compensation. The next step to extend this model is to
incorporate executive inside debt and re-examine the relevant issues (see, e.g., Colonnello, Curatola, & Hoang, 2017). In addition, we do
not model real investment decisions by risk-averse managers. Thus, incorporating investment decisions would be desirable because one
could then examine the effect of managerial compensation packages on the interaction between financing and investment decisions
under managerial discretion.

A Appendices

A.1 Proof of Proposition 1

HJB equation. First, we can show that the manager's optimization problem before bankruptcy is
"Z #
Td
eζðstÞ Uðcs ; as Þds þ eζT VðwT d Þ ;
d
Jðw; yÞ ¼ max E (32)
c;π ;a;b;T d 0

which is subject to the wealth dynamic (5). According to the standard dynamic programming method, Jðw; yÞ satisfies the following
Hamilton-Jacobi-Bellman (HJB) equation:

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ζJðw; yÞ ¼ max Uðc; aÞ þ ðrw þ π ðμR  rÞ þ φðy  f  m  bÞ þ m  c ÞJw ðw; yÞ
c;π ;a
)
ðπσ R Þ2 ðyσ Þ2 (33)
þυayJy ðw; yÞ þ Jww ðw; yÞ þ Jyy ðw; yÞ þ πρσσ R yJwy ðw; yÞ
2 2

First-order conditions. Differentiating the right-hand side of Equation (33) with respect to a, c, and π , we obtain the following first-
order conditions (FOCs):
 
υJy ðw; yÞ
a ðw; yÞ ¼ min ;1 ; (34)
θJw ðw; yÞ

Uc ðc; aÞ ¼ Jw ðw; yÞ; (35)

Jw ðw; yÞ μR  r Jwy ðw; yÞ ρσ

π ðw; yÞ ¼   y: (36)
Jww ðw; yÞ σ 2R Jww ðw; yÞ σ R
According to the utility indifference pricing principle (see Miao & Wang, 2007), we conjecture that the manager's value function is
given by Equation (11). Substituting (11) into the FOCs, we obtain ð15Þ, ð16Þ, and ð17Þ for the effort policy, consumption rule, and
portfolio allocation rule, respectively. Then, substituting Equations ð15Þ, ð16Þ, ð17Þ, and ð11Þ into ð33Þ, we obtain the ODE given in ð12Þ
for MðyÞ.
Boundary conditions. We now consider the boundary conditions. First, the HJB equation is subject to the transversality condition
 
limT→∞ erT JðwT ; yT Þ ¼ 0. In addition, at the instant of default, the manager is indifferent between continuing within the contracting
relationship with the principal and walking away with her reservation income. We thus have the following value-matching condition at
the default boundary yd ðwÞ:

Jðw; yd ðwÞÞ ¼ VðwÞ: (37)

Because the default boundary is optimally chosen by the manager, we also have the following smooth-pasting conditions at y ¼ yd ðwÞ
(see Chen et al., 2010):
 
∂Jðw; yÞ ∂VðwÞ
¼ ; (38)
∂w y¼yd ðwÞ ∂w y¼yd ðwÞ

 
∂Jðw; yÞ ∂VðwÞ
¼ : (39)
∂y y¼yd ðwÞ ∂y y¼yd ðwÞ

Substituting the post-bankruptcy and the pre-bankruptcy value functions ð10Þ and ð11Þ into the boundary conditions ð37Þ  ð39Þ, we
obtain ð13Þ and ð14Þ, respectively.

A.2 The market value of an unleveraged public firm absent agency frictions

We consider the case in which a well-diversified investor operates an unleveraged (all-equity financed) firm directly without the
manager. Importantly, the investor also receives a cash salary, but she must still bear the effort cost.
Let us denote by AðyÞ the market value of an unleveraged public firm absent agency frictions. An application of dynamic pro-
gramming yields the following ODE for AðyÞ:

θ ðσ yÞ2
rAðyÞ ¼ ð1  τÞðy  f  mÞ  ða Þ2 y þ νða ÞyA'ðyÞ þ A''ðyÞ; (40)
2 2

where the optimal effort policy a is given by

 
υA'ðyÞ
a ðyÞ ¼ min ;1 : (41)
θ
We solve the above ODE subject to the following boundary conditions. First, we have the no-bubble condition limy→∞ AðyÞ =y < ∞
when y → ∞. Second, whenever the revenue process reaches the abandonment threshold ya for the first time, the firm is abandoned.
Thus, at the threshold ya , we have the following value-matching condition:

Aðya Þ ¼ 0: (42)
Finally, because the abandonment threshold ya is chosen optimally, we also have the following smooth-pasting condition:

A'ðya Þ ¼ 0: (43)

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Appendix A. Supplementary data

Supplementary data to this article can be found online at https://doi.org/10.1016/j.iref.2019.08.003.

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