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Authors:

• Sudipto SARKAR
  McMaster University

• Kiridaran KANAGARETNAM
  McMaster University

• Robert MATHIEU
  Wilfrid Laurier University

This paper examines the interaction of management compensation structure with the under-investment agency problem. Aligning the manager’s interests too closely with stockholders will result in sub-optimal investment policies and increase the agency cost of debt. We derive a simple expression for the optimal managerial ownership, that will induce the manager to follow a first-best (firm-value-maximizing) investment policy. It is shown that the optimal managerial ownership is, in general, quite small, consistent with empirical evidence. The optimal managerial ownership is an increasing function of the manager’s fixed salary and the company’s earnings growth rate, and a decreasing function of leverage ratio, earnings volatility, tax rate and bankruptcy costs. However, if the ratio of the manager’s fixed salary to the firm’s total coupon obligation is unchanged, neither the fixed salary nor the leverage ratio will have any effect on the optimal managerial ownership. Empirical tests with a sample of firms from the ExecuComp database provide support for the model’s predictions.