ARTICLE IN PRESS
Journal of Accounting and Economics 43 (2007) 69–93 www.elsevier.com/locate/jae
Executive compensation and capital structure: The effects of convertible debt and straight debt on CEO pay$ Hernan Ortiz-MolinaÃ
Sauder School of Business, The University of British Columbia, 2053 Main Mall, Vancouver, BC, Canada V6T 1Z2 Received 4 April 2005; received in revised form 22 September 2006; accepted 28 September 2006 Available online 16 November 2006
Abstract I examine how CEO compensation is related to ﬁrms’ capital structures. My tests address the simultaneity of these decisions and distinguish between debt types with different theoretical implications for managerial incentives. Pay–performance sensitivity decreases in straight-debt leverage, but is higher in ﬁrms with convertible debt. Furthermore, stock option policy is the component of CEO pay that is most sensitive to differences in capital structure. The results strongly support the hypothesis that ﬁrms trade-off shareholder-manager incentive alignment in order to mitigate shareholder-bondholder conﬂicts of interest. The hypothesis that debt reduces managershareholder conﬂicts can explain some but not all of the results. r 2006 Elsevier B.V. All rights reserved. JEL classiﬁcation: G32; G34; J33; D82 Keywords: Executive compensation; Corporate governance; Agency problems; Capital structure
$ This paper is derived from my doctoral dissertation at the University of Maryland. I thank especially my thesis committee, Roger Betancourt, Gordon Phillips, Nagpurnanand Prabhala, Lawrence Ausubel, and Ginger Jin. Thanks also to Samuel Berlinski, Martin Boyer, Murray Carlson, Gilles Chemla, Alan Douglas, Jerry Feltham, Adlai Fisher, Murray Frank, S.P. Kothari (the Editor), Kin Lo, an anonymous referee, and seminar ´ participants at HEC Montreal, Tilburg University, University of British Columbia, University of Maryland, University of Warwick, Norwegian School of Management, Stockholm School of Economics, and participants at the 19th Annual Paciﬁc Northwest Finance Conference 2003 and the Northern Finance Association Meetings 2003. I gratefully acknowledge the ﬁnancial support from the Social Sciences and Humanities Research Council of Canada. A previous version of the paper circulated under the title ‘‘Does capital structure matter in setting CEO pay?’’. ÃTel.: +1 604 822 6095; fax: +1 604 822 4695. E-mail address: email@example.com.
0165-4101/$ - see front matter r 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2006.09.003
ARTICLE IN PRESS
70 H. Ortiz-Molina / Journal of Accounting and Economics 43 (2007) 69–93
1. Introduction Modern agency theory suggests that a ﬁrm’s ﬁnancial structure can affect the agency relationship between shareholders and managers, and also that conﬂicts of interest between shareholders and bondholders can affect the provision of optimal incentives to managers. However, assuming that capital structure is unimportant to understand how ﬁrms set their compensation packages, studies of executive compensation typically ignore the role of ﬁrms’ capital structures. This paper shows that capital structure matters in setting executive pay, and sheds light on the nature of this relation. The null hypothesis is that capital structure and CEO pay are not related. However, these decisions are likely to be simultaneously determined, since ﬁrms can minimize the agency costs created by managerial discretion and misaligned incentives by optimizing jointly over capital structure and compensation decisions. Capital structure can affect CEO compensation through two (non exclusive) channels. The agency cost of equity hypothesis suggests that debt mitigates shareholder–manager agency problems by inducing lenders to monitor, reducing the free cash ﬂow available to managers, and forcing managers to focus on value maximization when facing the threat of bankruptcy (e.g., Jensen, 1986; Grossman and Hart, 1982). Thus, higher...
References: Aggarwal, R.K., Samwick, A.A., 1999. The other side of the trade-off: the impact of risk on executive compensation. Journal of Political Economy 107, 65–105. Agrawal, A., Knoeber, C.R., 1996. Firm performance and mechanisms to control agency problems between managers and shareholders. Journal of Financial and Quantitative Analysis 31, 377–397. Amemiya, T., 1982. Two stage least absolute deviations estimators. Econometrica 50, 689–712. Brander, J.A., Poitevin, M., 1992. Managerial compensation and the agency costs of debt ﬁnance. Managerial and Decision Economics 13, 55–64. Brennan, M.J., Kraus, A., 1987. Efﬁcient ﬁnancing under asymmetric information. Journal of Finance 42, 1225–1243. Bryan, S., Hwang, L., Lilien, S., 2000. CEO stock-based compensation: an empirical analysis of incentiveintensity, relative mix, and economic determinants. Journal of Business 73, 661–693.
ARTICLE IN PRESS
92 H. Ortiz-Molina / Journal of Accounting and Economics 43 (2007) 69–93 Coles, J.L., Daniels, N.D., Naveen, L., 2006. Managerial incentives and risk taking. Journal of Financial Economics 79, 431–468. Datta, S., Iskandar-Datta, M., Raman, K., 2001. Executive compensation and corporate acquisition decisions. Journal of Finance 56, 2299–2336. Gibbons, R., Murphy, K.J., 1992a. Optimal incentive contracts in the presence of career concerns: theory and evidence. Journal of Political Economy 100, 468–505. Gilson, S.C., Vetsuypens, M.R., 1993. CEO Compensation in ﬁnancially distressed ﬁrms: an empirical analysis. Journal of Finance 48, 425–458. Gomez, A., Phillips, G., 2005. Why do public ﬁrms issue private and public securities? Unpublished Working paper. Green, R.C., 1984. Investment incentives, debt, and warrants. Journal of Financial Economics 13, 115–136. Grossman, S., Hart, O., 1982. Corporate ﬁnancial structure and managerial incentives. In: McCall, J. (Ed.), The Economics of Information and Uncertainty. University of Chicago Press, Chicago. Guay, W.R., 1999. The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and determinants. Journal of Financial Economics 53, 43–71. Hall, B.J., Murphy, K.J., 2002. Stock options for undiversiﬁed executives. Journal of Accounting and Economics 33, 3–42. Ittner, C.D., Lambert, R.A., Larcker, D.F., 2003. The structure and performance consequences of equity grants to employees of new economy ﬁrms. Journal of Accounting and Economics 34, 89–127. Jensen, G.R., Zolberg, D.P., Zorn, T., 1992. Simultaneous determination of insider ownership, debt, and dividend Policies. Journal of Financial and Quantitative Analysis 27, 247–263. Jensen, M., 1986. Agency costs of free cash-ﬂow, corporate ﬁnance, and takeovers. American Economic Review 76, 323–329. Jensen, M., Meckling, W., 1976. Theory of the ﬁrm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3, 305–360. Jensen, M., Murphy, K.J., 1990a. Performance pay and top-management incentives. Journal of Political Economy 98, 225–264. John, K., Mehran, H., Qian, Y., 2003. Regulation, subordinated debt and incentive features of CEO compensation in the banking industry. Unpublished working paper. John, T.A., John, K., 1993. Top-management compensation and capital structure. Journal of Finance 48, 949–974. Krishnaswami, S., Yaman, D., 2004. The role of convertible bonds in alleviating contracting costs. Unpublished working paper. Lambert, R., Larcker, D., Verrecchia, R., 1991. Portfolio considerations in valuing executive compensation. Journal of Accounting Research 29, 129–149. Lewellen, W.G., Loderer, C., Martin, K., 1987. Executive compensation and executive incentive problems: an empirical analysis. Journal of Accounting and Economics 9, 287–310. Lewis, C.M., Rogalski, R.J., Seward, J.K., 1998. Agency problems, information asymmetries, and convertible debt security design. Journal of Financial Intermediation 7, 32–59. Lewis, C.M., Rogalski, R.J., Seward, J.K., 1999. Is convertible debt a substitute for straight debt or for common equity? Financial Management 28, 5–27. Matsunaga, S.R., 1995. The effects of ﬁnancial reporting costs on the use of employee stock options. The Accounting Review 70, 1–26. Mayers, D., 1998. Why ﬁrms issue convertible bonds: the matching of ﬁnancial and real investment options. Journal of Financial Economics 47, 83–102. McDaniel, M., 1986. Bondholders and corporate governance. Business Lawyer 41, 413–460. Mehran, H., 1995. Executive compensation structure, ownership and ﬁrm performance. Journal of Financial Economics 38, 163–184. Mikkelson, W., 1981. Convertible calls and security returns. Journal of Financial Economics 9, 237–264. Myers, S.C., 1977. Determinants of corporate borrowing. Journal of Financial Economics 5, 147–175. Ofek, E., Yermack, D., 2000. Taking stock: equity-based compensation and the evolution of managerial ownership. Journal of Finance 55, 1367–1384. Ortiz-Molina, H., 2006. Top-management incentives and the pricing of corporate public debt. Journal of Financial and Quantitative Analysis 41, 317–340. Parrino, R., Weisbach, M.S., 1999. Measuring investment distortions arising from stockholder–bondholder conﬂicts. Journal of Financial Economics 53, 3–42.
ARTICLE IN PRESS
H. Ortiz-Molina / Journal of Accounting and Economics 43 (2007) 69–93 93 Rajan, R.G., Zingales, L., 1995. What do we know about capital structure? Some evidence from international data. Journal of Finance 50, 1421–1460. Rajgopal, S., Shevlin, T., 2002. Empirical evidence on the relation between stock option compensation and risk taking. Journal of Accounting and Economics 33, 145–171. Smith, C.W., Warner, J.B., 1979. On ﬁnancial contracting: analysis of bond covenants. Journal of Financial Economics 7, 175–219. Smith, C.W., Watts, R.L., 1992. The investment opportunity set and corporate ﬁnancing, dividend and compensation policies. Journal of Financial Economics 32, 263–292. Stein, J., 1992. Convertible debt as backdoor equity ﬁnancing. Journal of Financial Economics 32, 3–21. Strock Bagnani, E., Milonas, N.T., Saunders, A., Travlos, N.G., 1994. Managers, owners, and the pricing of risky debt: an empirical analysis. Journal of Finance 49, 453–477. Yermack, D., 1995. Do corporations award CEO stock options effectively? Journal of Financial Economics 39, 237–269.
Please join StudyMode to read the full document