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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 protected]
0165-4101/$ - see front matter r 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2006.09.003
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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...
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