Journal of Financial Economics 00 (2002) 000-000 Leverage decision and manager compensation with choice of effort and volatility Abel Cadenillas a , Jakˇ sa Cvitani´ c b , Fernando Zapatero c,∗ a University of Alberta, Department of Mathematical and Statistical Sciences, Edmonton, Alberta, Canada b USC, Departments of Mathematics and Economics, Los Angeles, CA 90089, USA c USC, Marshall School of Business, FBE, Los Angeles, CA 90089, USA (Received 10 October 2002; accepted: 16 June 2003) ———————————————————————————————————— Abstract We study the incentive effects of granting levered or unlevered stock to a risk-averse manager. The stock is granted by risk-neutral shareholders who choose leverage and compensation level. The manager applies costly effort and selects the level of volatility, both of which affect expected return. The results are driven by the attempt of the risk-neutral shareholders to maximize the value of their claims net of the compensation package. We consider a dynamic setting and find that levered stock is optimal for high-type managers, firms with high momentum, large firms, and firms for which additional volatility only implies a modest increase in expected return. JEL Classification: C61, G39 Keywords: Capital structure, principal-agent, stochastic control ———————————————————————————————————— The research of A. Cadenillas was supported by the Social Sciences and Humanities Research Council of Canada grant 410-2000-0631. The research of J. Cvitani´ c was supported in part by the National Science Foundation, under Grant NSF-DMS-00-99549. This paper is based on a previous paper titled “Executive Stock Options with Effort Disutility and Choice of Volatility.” We are especially grateful to Kevin Murphy for many detailed comments on that paper. We also thank H´ ector Chade, Li Jin, Fulvio Ortu, Rafael Repullo, Manuel Santos, Luigi Zingales, and seminar participants at HEC (Montreal), NYU, McGill, USC, Princeton, Wharton, BI (Oslo), Copenhagen School of Business, California Institute of Technology, Florida International University, CEMFI, ASU, Humboldt Universit¨at zu Berlin, the Winter 2000 Meeting of the Canadian Mathematical Society, the 2001 Canada-China Math Congress, and the Second World Congress of the Bachelier Finance Society (2002) for comments. Last, but not least, many comments and suggestions of an anonymous referee (including a key note with regard to the focus of the paper) are gratefully acknowledged. Existing errors are our sole responsibility. * Corresponding author: Fernando Zapatero Email: fzapatero@marshall.usc.edu 0304-405X/02/ $ see front matter c  2002 Published by Elsevier Science S.A.