JOURNAL OF FINANCIAL INTERMEDIATION 2, 376-400 (1992) Optimal Capital Structure for a Hierarchical Firm* GERALD GARVEY AND PETER L. SWAN Australian Graduate School of Management, University of New South Wales, P.O. Box 1, Kensington, NSW 2033, Australia Received February 20, 1991 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 hierar- chy increases. This and other implications of the model square well with existing evidence and suggest new directions for empirical work. Journal of Economic Literature Classification Numbers: G32, G33, 541. o 1992 Academic PESS, IIK. I. INTRODUCTION In the traditional corporate finance literature, the senior managers’ main task is to select investment projects. This paper examines optimal financial arrangements for firms in which the management of labor is more important than the management of capital. We follow the existing litera- ture by modeling the effect of outside claims on the decisions of a repre- sentative corporate insider, whom we term the “CEO” (see, e.g., Jensen and Meckling, 1976; Myers, 1977; Townsend, 1979). The CEO’s key role, however, is to provide incentives to subordinates rather than to select * For useful comments on earlier drafts of this paper, we thank Mitchell Berlin, David Hirshleifer, Charles Kahn, Wayne Lee, Eric Rasmusen, David Sappington, Anjan Thakor, and seminar participants at the Commerce Department, University of Queensland, Hoover Institute at Stanford University, and the 1991 Hilliard-Lyons Symposium at the Graduate School of Business, Indiana University. 376 1042-9573192 $5.00 Copyright 8 1992 by Academic Press, Inc. All rights of reproduction in any form reserved.