Optimal capital structure with moral hazard

This paper extends the classic optimal capital structure model to the case of moral hazard based on the principal-agent problem, where the firm's output dynamically depends on the agent's efforts. We derive closed-form results for the value of risky debt, credit spread, default threshold, and for optimal capital structure with moral hazard. The numerical results indicate that the firm issues more debt with higher coupon ex ante and defaults earlier ex post than without manager moral hazard. The different initial values of firms' cash flow induce different risk preferences of the manager to his value and consequently the manager acts in the opposite approaches especially when the firm is on the verge of bankruptcy. The paper also consider the occasions in which hiring a manager is optimal for the principal.