Date of Award

Spring 4-25-2012

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Risk Management and Insurance

First Advisor

Ajay Subramanian

Abstract

This thesis consists of three chapters on financial structure, managerial compensation, and product markets. The unifying theme of these chapters is to examine how the financial decisions of firms are affected by market imperfections. Chapter 1 places emphasis on the impact of internal imperfections arising from asymmetric beliefs (or behavioral biases) and agency conflicts by examining how these internal imperfections affect managerial compensation and corporate financial structure. On the other hand, Chapters 2 and 3 incorporate external market imperfections especially arising from imperfect product market competition. More specifically, these two chapters develop market equilibrium frameworks to examine how the matching market for CEOs and firms interacts with the product market to affect the distributions of CEO compensation and firm size.

In Chapter 1, we develop a dynamic model to examine the effects of asymmetric beliefs of a firm's manager and blockholders regarding the profitability of the firm's projects, and differing attitudes towards their risk, on its capital structure. The firm's capital structure reflects the tradeoff between the positive incentive effects of managerial optimism that increases the manager's output and blockholders' private benefits against the negative effects of risk-sharing costs. We provide several testable implications for the effects of the degree of managerial optimism as well as permanent and transitory components of the firm's risk on different components of capital structure. In our calibration of the model, performed separately for different industries, we show that while optimism and risk have qualitatively similar effects on capital structure in different industries, their quantitative effects are significantly different. The interactive effects of asymmetric beliefs and agency conflicts could potentially explain a significant portion of the substantial inter-industry variation in capital structure.

Chapter 2 studies how the distributions of CEO talent and compensation vary across industries, and how product market characteristics affect these distributions. We develop a market equilibrium model that incorporates the competitive assignment of CEOs to firms in a framework in which firms engage in imperfect product market---specifically, monopolistic---competition. Using the distributions of CEO pay and firm value in each of twelve Fama-French industries, we calibrate the parameters of our structural model, and indirectly infer the unobserved distributions of CEO talent and firm quality that together determine firm output. We then conduct several counterfactual experiments using the calibrated models corresponding to each of the industries. We find that the distribution of CEO talent does, indeed, vary dramatically across industries. More importantly, contrary to the conclusions of earlier studies that abstract away from the effects of the product market (Tervio, 2008 and Gabaix and Landier, 2008), the impact of CEO talent on firm value appears to be quite significant. Our estimates of the effect of CEO talent on firm value for the industries in our sample are two orders of magnitude higher than those obtained by the aforementioned studies. Further, our estimates suggest that the compensation of CEOs is quantitatively in line with their contributions to firms. Broadly, our study shows that it is important to incorporate the product market environment in which firms operate when assessing the contributions of CEOs to firms.

Chapter 3 builds a market equilibrium framework in which the CEO-firm matching process is affected by the product market. We show that under reasonable assumptions there is a unique equilibrium in which only managers with ability above a unique cutoff level are matched to firms. This very simple screening process endogenizes the distribution of active managers who match with firms. Our calibration of the model using a parametric approach, which is in contrast with the empirical analysis performed in Chapter 2, strongly supports the principle arguments on the importance of CEO talent and appropriate CEO talent levels (on average) in Chapter 2. In addition, due to the law of demand and supply, which is a key feature of the extended model, we obtain somewhat different influence of some of product market characteristics on CEO pay. Furthermore, our parametric approach allows us to draw some implications for the effects of CEO talent distribution on the market equilibrium.

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