Corporate finance over the past 25 years - Financial Management Silver Anniversary Commemoration

Financial Management (Financial Management Association), Summer, 1995 by Michael J. Brennan

Under the standard assumptions, managerial behavior will be influenced by the choice of compensation function as well as by the threat of replacement. Optimal managerial compensation functions that take account of managerial moral hazard have been extensively analyzed.(18) One puzzle that has attracted attention is the heavy dependence of executive compensation on accounting earnings rather than stock prices, since it is the stock price that investors are assumed to want to maximize. Paul (1992) shows that stock-based compensation can lead to substantial inefficiency because making compensation depend on the stock price constrains the manner in which information about individual project payoffs enters the compensation function. Perhaps a more general limitation of the moral-hazard-based theories of executive compensation is an overly stylized representation of the moral hazard problem itself as one simply of effort aversion: While this may be a major problem in share-cropping on which much of this literature is based, it may well be that shareholders are more concerned with counteracting managerial risk aversion, discouraging the pursuit of grandiose managerial visions at their expense, or ensuring that managers distribute the rents earned by the firm to shareholders rather than to employees or other groups.(19) As yet, little attention has been directed to the effect of managerial compensation on the ability of the manager to successfully lead a team of employees,(20) or to bargain with other stakeholders in the corporation.(21) Hirshleifer and Thakor (1992) and Narayanan (1985) analyze the effects of managerial career considerations on compensation schemes and managerial behavior.

V. Corporate Control, Monitoring, and Financial Intermediation

A new concept or motive for behavior introduced in the corporate finance literature is the non-pecuniary benefit allegedly received by those in control of the corporation. This non-pecuniary benefit has implications for the voting structure of the corporation and has been used to justify the assignment of votes to equity on a one-share-one-vote basis by Grossman and Hart (1988) and Harris and Raviv (1989).

More significantly, the non-pecuniary benefits obtained by the manager of an operating corporation may make him reluctant to liquidate the corporation even when it is socially optimal to do so. The infeasibility of writing contracts that will compel the manager to liquidate at the optimal time has led to the development of a line of theory in which the role of capital structure is to ensure socially optimal liquidation. The earliest paper to be concerned with socially optimal liquidation was Titman (1984) although, unlike subsequent writers, his analysis omitted any reference to the non-pecuniary benefits of control. More recent work by Aghion and Bolton (1992) has focused on the role of securities in re-allocating control between different contracting parties in a world of incomplete contracts.

The non-pecuniary benefits of control and the consequent tendency of managers to continue projects when it would be socially efficient to liquidate them have provided the basis also of theories of debt maturity (Diamond, 1993) and the role of financial intermediaries as monitors (Rajan, 1992).(22)