This paper analyzes the optimal financial structure for a firm in which the top manager must provide incentives to a subordinate in addition to exerting directly productive efforts. Optimal capital structure is shown to involve a moderate level of debt with a substantial penalty for default, and passive shareholders. In a two- or three-layer hierarchy, optimal leverage is shown to decrease as either the number of hierarchical levels or the importance of agents further down the hierarchy increases. This and other implications of the model square well with existing evidence and suggest new directions for empirical work.

Worker incentive schemes are invariably assumed to be administered by an owner-entrepreneur who has an incentive to understate worker performance after the event. While tournaments can overcome this problem, they discourage cooperation between workers. We show that a professional manager concerned with equality between workers and with avoiding bankruptcy rather than maximizing shareholder wealth will conduct a tournament that preserves individual effort incentives while promoting cooperation between workers. The theory predicts lower debt levels and more compressed pay scales as cooperation becomes more important. In the limit this becomes a group bonus scheme, supported by "blue-chip" debt.