Hart, Oliver, and John Moore, “Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management,” The American Economic Review, Vol 85, No 3 (1995), 567-585.
- Assume that managers will always invest in every project (due to empire-building, prestige, resumé-building, etc.)
- If managers have too much cash flow, they will invest in bad (negative NPV) projects along with good ones.
- Debt can fix the agency problem by forcing managers to pay out cash flows before investing.
- The debt overhang problem
- If managers have too little cash, they will have to forgo investing in good projects.
- If managers have too much debt, they will not risk losing their job and, again, will forgo investing in good but risky projects.
- Long-term debt can outperform complicated contracts in solving agency problems.
- Contracts that attempt to align manager compensation with shareholders’ interests can’t address every agency problem.
- Long-term debt restricts managers from borrowing against future cash flows to invest in bad projects.