Firm-Specific Human Capital and Optimal Capital Structure.

The authors consider the moral hazard in managers undersupplying imperfectly-marketable, firm-specific human capital. Firms may cope by granting long-term wage contracts that protect managers against employment termination. Although ex ante efficient, these contracts may be ex post inefficient when managerial ability is discovered to be low. Precommitted firms must honor these contracts, unless there is ownership transfer that permits their legal invalidation. Bankruptcy is one such transfer mechanism. Since managers anticipate the contractual consequence of bankruptcy, leverage worsens moral hazard; this cost provides a counterbalance to the debt tax shield and leads to an optimal capital structure. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Human Capital, Bankruptcy, and Capital Structure

We derive the optimal labor contract for a levered firm in an economy with perfectly competitive capital and labor markets. Employees become entrenched under this contract and so face large human costs of bankruptcy. The firm's optimal capital structure therefore depends on the trade-off between these human costs and the tax benefits of debt. Optimal debt levels consistent with those observed in practice emerge without relying on frictions such as moral hazard or asymmetric information. Consistent with empirical evidence, persistent idiosyncratic differences in leverage across firms also result. In addition, wages should have explanatory power for firm leverage. Copyright (c) 2010 the American Finance Association.