Essays in capital structure

This dissertation consists of two essays. The first essay provides a theoretical explanation for why leverage is negatively correlated with profitability. It also examines why capital structure varies across industries as well as within one industry. The second essay examines how capital structure can be employed in mitigating the agency problems and improving the efficiency of compensation scheme to the management.; The empirical literature on capital structure suggests a negative relation between profitability and leverage. It is not consistent to one of the central implications of the trade-off model. The first essay of this thesis develops a model also in the framework of the trade-off model and scrutinizes capital structure decision in a general equilibrium. The model shows the relation between profitability and leverage can be negative if asset liquidity is endogenous and profit realizations are not independent across firms. The firms confront the trade-off between paying more to the investors to reduce the chance of liquidation and holding more cash to buy liquidated assets at prices below best use value. In equilibrium, the more profitable firms hold more cash and are less leveraged. Moreover, the model also implies the relative profitability of firms to its peers could be an additional determinant of capital structure and the inter-industry capital structure variation is partially due to the different type distributions of firms.; The second essay is motivated by the well documented fact of the insignificant relation between compensation of the management and performance of the firms. Performance-sensitive compensation is introduced to overcome certain kind of agency problem. It nonetheless incurs some others. The second chapter considers the optimal compensation and capital structure at the same time. It is demonstrated that capital structure is an indispensable instrument to mitigate agency problems when hidden action and hidden information both exit. It implies the principals prefer to offer less equity or stock options but higher basic salary to the agents, which actually mitigates several kinds of agency problems besides the hidden action. Furthermore, in an economy with more than one firm, market updates its belief based on the debt payment of all firms, the optimal capital structures and compensation schemes of firms are thus inter-dependent.