Endogenous Managerial Incentives and the Optimal Combination of Debt and Dividend Commitments

Byline: Alan V. Douglas (1) Keywords: Managerial Information Advantages; Endogenous Objective Functions; Financial Commit-ments; Agency Costs; Dividend Puzzle Abstract: This paper studies the optimal combination of debt and dividend commitmentsin an agency model of the firm. Financial policy is relevant because ex-post information asymmetry requires managerial rewards to depend on the ability to meet financial commitments. If perquisite or inside information problems exist in isolation, debt-based incentives as assumed in previous studies result endogenously. If the problems exist simultaneously, dividends can be optimal even when they appear excessively costly as a signal and unduly lenient as a disciplining device. The reason is that the set of dynamically consistent rewards increases when debt commitments are augmented with dividend commitments, and a larger set of ex-post rewards is more valuable as ex-antedecisions become more complex. Author Affiliation: (1) School of Accountancy, Centre for Advanced Studies in Finance, University of Waterloo, Waterloo, Ontario, Canada, N2L 3G1 Article History: Registration Date: 10/10/2004