Leverage, Risk‐shifting Incentive, and Stock‐based Compensation

Abstract

Outstanding risky debt provides risk-shifting incentives for managers fully aligned with stockholders. Earlier research shows that the risk-shifting incentive can be eliminated by using a stock-based compensation design to align managers' and stockholders' interests. I show that stock options as well as compensation designs that align managers' and bondholders' interests eliminate the risk-shifting incentive. Although a stock-based compensation design is not a unique mechanism to eliminate the pure risk-shifting incentive, it is essential where managers of levered firms are known to consume a portion of the investment outlay as perquisites.

Stock options and capital structure

“…This corollary finds empirical support in Lambert, Lanen, and Larker (1989). While here we show that convexity induces a managerial preference for debt over all other sources of external financing, parallel conclusions have been reached in the literature with regard to project selection, namely, that convexity of executive compensation induces a managerial preference for riskier projects (see for example, Bizjak, Brickley, and Coles 1993;Defusco, Johnson, and Zorn 1990;Guay 1998;Harikumar 1996;Garvey and Mawani 1998).…”

Risk-taking incentives of executive stock options and the asset substitution problem

“…We now turn attention to the case where the manager can exert costly effort, which increases the probability that the risky investment will pay off. Harikumar (1996) studies a similar problem but follows John and John (1993) by restricting X = 0. For simplicity, we now assume there are only two values of q, q H and q L and the condition q H H > I > q L H…”

“…14 Information about option awards such as the number of options granted, the exercise price, and the date of grant are published 12 See Persons (1994) for a rigorous justification of this non-value-maximizing policy based on the need to write a contract, which shareholders will not renegotiate ex post. 13 For examples of alternative schemes that induce optimal investment, see Haugen and Senbet (1981) on the use of put as well as call options, and Harikumar (1996) on changes in the timing and structure of wage and stock-based pay. 14 A majority of the Canadian option-granting large publicly traded firms are listed on the Toronto Stock Exchange and, therefore, fall within the jurisdiction of the Ontario Securities Commission.…”

Accounting for Option–based Compensation: The Economic Cost Approach

“…2 This approach is very similar to the`marked to market' approach in the futures market. 3 Please see, Haugen and Senbet (1981) for a discussion on stockholdermanager alignment, John and John (1993) and Harikumar (1996) for a discussion of the impact of option-based compensation on managers' investment decisions, Smith and Watts (1983) and Mehran (1992) for empirical results.…”