Capital Structure, Investment, and Private Benefits of Control

The recent law and finance literature following Shleifer and Vishny (1997) and La Porta, Lopez-de Silanes, and Shleifer (1998) argues that the expropriation of minority shareholders by controlling shareholders is at the core of agency conflicts in most countries. While much empirical evidence has been accumulated regarding the importance and effects of this particular type of conflict, theoretical work in this area has largely been qualitative, focusing only on directional effects. This paper builds a contingent claims model in which a controlling shareholder can divert part of the firm's cash flows as private benefits at the expense of minority shareholders. In this environment, we examine the impact of the opportunistic behavior of the controlling shareholder on investment and financing decisions. The model shows that conflicts of interests among shareholders can explain the low debt levels observed in practice. It also examines the impact of agency conflicts on firms' investment decisions and the cross-sectional variation in capital structures.