The Role of Debt in Motivating Organizational Efficiency

One of the factors, that influences capital structure of companies, is conflict of interest between shareholders and managers. This theory, which belongs among the main capital structure theories, is also related to the theories that are talking about the role of agency conflicts between these parties. The reason of this conflict is free cash flow that can be either redistributed to the shareholders by dividends or utilized as an investment. On the one hand, shareholders generally want high returns on their equity, so they are expecting that free cash flow will be redistributed to them through dividends. On the other hand, managers want maximize their power and wealth in a company by investing into projects that is not in the best interst of shareholders. According to Jensen (1986), company can reduce agency costs of free cash flow through a debt issue and he called this theory „control hypothesis “.

Literature related to debt financing is often focused on agency costs of debt but the benefits of this type of financing in relation to company efficiency are rarely mentioned. As has been already said, managers want to invest free cash flow to empower their position although some of the investment projects are not very profitable. If free cash flow of a firm is high, managers can either increase dividends or repurchase stocks thereby they will avoid of investing into inefficient projects. The problem of this solution is that control over the future cash flows of a company remains henceforth in the hand of managers. The next option is an issue of bonds in the exchange for stocks. By issuing debt, managers are bonding their promises to pay out future cash flows. Shareholders who obtained the bonds in the replacement of their shares, can enforce their rights for an interest which were promised to them before an exchange. If managers will not pay out this interest, the holders of these bonds have got a right to take a firm into a bankruptcy. In other words, „Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows” (Jensen; 1986). Thus, by reducing of free cash flow that is available for spending of managers, the agency costs of free cash flow are decreased.         

According to Jensen, control effect of debt is a potential determinant of capital structure.

One can notice that debt issue could be an executive tool for increasing company efficiency, however “control hypothesis “ doesn’t claim that it always works in a good manner. This hypothesis doesn’t play a big role in companies which are growing very fast, because they often haven’t got any free cash flow. In the contras with these firms, corporations which haven’t got a big growing potential, but they’ve got a big amount of free cash flow, should be aware of the role of debt in motivating of organizational efficiency. Moreover, an exchange of stocks for debt is also lucrative from the view of tax management of companies, because interest payments are deductible for firms and that part of the repurchase proceeds equal to the seller's tax basis in the stock is not taxed at all.