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|Title: ||Contingent Control Rights and Managerial Incentives: The Design of
|Authors: ||Fluck, Zsuzsanna|
|Keywords: ||security design|
nonverifiability of cash flows,
managerial moral hazard
managerial asset substitution.
|Issue Date: ||1-Nov-1999 |
|Series/Report no.: ||FIN-99-070|
|Abstract: ||Enterprises, small or large, rely heavily on long-term financing
arrangements to fund their operations. However, it has proved difficult
for financial theory to justify the use of long-term contracts when the
manager has the ability to divert or manipulate the cash flows, and when
it is prohibitively costly for a third party, such as a court, to verify
or prove any managerial wrongdoing. Why would investors enter into
financial contracts that extend beyond the life of the firm's existing
physical assets when such contracts rely on the manager to make repeated
investments during the life of the contract? How can investors induce
the manager to make these investments when such investments cannot be
contracted upon? In this paper we show that with the appropriate design
of the control rights longer-term debt contracts can become sustainable.
In particular, investors are willing to hold long-term debt if they are
granted (1) the right to dismiss the manager and to take over the
company as a going concern upon default; or (2) the right to dismiss the
manager and to extend the maturity of the debt in default.
Interestingly, it is the threat of dismissal that induces management to
comply with the contract but it is the investors' ability to extend the
maturity of the debt in default that makes this threat credible.
Empirical evidence reported by Gilson (1990, 1993), Gilson, John and
Lang (1990), Franks and Torous (1993, 1994), Franks, Nyborg and Torous
(1996), Franks and Sussman (1999) supports our view that creditors'
right to dismiss manager and to take equity or to extend the maturity of
the debt in default plays a key role in enforcing the repayment of debt.
Once we established that long-term debt is sustainable, the natural
question to ask is whether investors would be indifferent between
long-term debt and outside equity or whether they would prefer one over
the other. Despite the strong similarity of the control rights and the
maturity of debt and equity, investors will not be indifferent between
the two securities in our model. If a project can raise long-term debt
it can also raise outside equity but the reverse is not true: there are
projects that cannot issue debt but may still obtain outside equity
financing. This is so because of the nature of the control rights. Since
debtholders have contingent control rights, they cannot exercise control
unless default has occurred. Hence, the manager can devise more
profitable default strategies by planning his default ahead of time and
milking the assets prior to default. Since contingent control rights
allow the manager more opportunities for wealth transfer from investors
off the equilibrium path than unconditional rights, long-term debt
contracts must offer the manager substantially higher incentive payments
in equilibrium than equity. Thus, a project aiming to secure longer-term
debt financing must show evidence of higher expected profitability than
one seeking equity financing.|
|Appears in Collections:||Finance Working Papers|
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