Academic journal article International Journal of Management

Cost of Capital as a Moderator of the Effect of Equity-Based Compensation on Risk-Taking by Managers

Academic journal article International Journal of Management

Cost of Capital as a Moderator of the Effect of Equity-Based Compensation on Risk-Taking by Managers

Article excerpt

Agency theory and contract theory predict that compensation contract can be designed to reduce the agency cost of equity and agency cost of debt in terms of risk taking by managers. Prior empirical studies focus on cost of equity effect and find that equity-based compensation reduces agency cost of equity by providing manager incentives to increase firm's risk. This study takes into account of cost of debt to argue that agency cost of debt as measured by financial leverage affects the association between equity-based compensation and risk taking by managers. The paper analyzes a sample of 2,017 American firms over the period from 1992 to 2004 by use of the simultaneous equation models, which address the simultaneity of compensation decisions by board of directors and risk taking decisions by managers. The results show that chief executive officers (CEOs) act differently for firms with different financial leverage and different types of debt. Specifically, the sensitivity of CEO wealth to stock returns volatility (Vega) has a lower impact on risk taking for debt-financed firms than all-equity firms, while the sensitivity of CEO wealth to stock price (Delta) has a higher impact on risk taking for debt-financed firms than all-equity firms, where risk taking by managers is measured as observable risky investment decisions, Research and Development (R&D) investments. The results hold even after controlling for the effects of firm's size, investment opportunities, surplus cash, and sales growth. The results support the argument that equity-based compensation mitigates agency cost of debt in addition to agency cost of equity in terms of risk taking by managers.

Introduction

Modern corporations are characterized by a separation of ownership and control. There are two main conflicts of interest within the modern corporation, the conflict of interest between shareholders and managers, and the conflict of interest between shareholders and bondholders.

The first conflict arises when shareholders find it efficient to delegate decision-making to managers, but managers want to maximize their own benefits instead of those of the shareholders. The alignment of shareholders' and managers' interests has become the main task of corporate governance. This conflict may arise in terms of managers' choice of effort or risk. Shareholders prefer that managers provide effort to improve output. If managers incur a personal cost for providing effort, and that managerial effort is not observable (or inferable) by shareholders, then managers have an opportunity to choose actions that increase benefit that accrue to them only. In addition, managers and shareholders may differ in their attitudes toward risk taking. Relative to shareholders, managers are assumed more risk averse due to human capital risk as well as less diversified of their wealth portfolios. They may choose to avoid risk-increasing positive NPV projects that benefit shareholders. Shareholders care only about expected NPV payoff of the project (not risk), while managers care about both.

The second conflict within corporations is the one between shareholders and bondholders. The payoff to equity value in a levered firm can be viewed as a call option where the underlying asset is the firm's asset value and the exercise price is the face value of debt. Since the value of call options - equity value - increases with the variance of the underlying asset, the value of common stock increases with the volatility of the firm's cash flows. Jensen and Meckling (1976) argue that excessive debt creates incentives for shareholders to take on risk-increasing negative NPV projects at the expense of debtors. This is referred to as the asset substitution problem. Since shareholders have limited liability if the firm does not perform well, they may prefer to shift to high risk negative NPV investment, believing that they are playing with other people's money.

Previous theoretical studies have demonstrated that incentive compensation contracts can be used to minimize both (1) agency costs of equity and (2) agency costs of debt. …

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