Top‐Management Compensation and Capital Structure

Abstract

The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device t o minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negutiue relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy (1990) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization.

The Effect of Overconfidence on the Sensitivity of CEO Wealth to Equity Risk

“…Second, we find that banks with higher levels of debt provide CEOs with weaker risk-taking incentives. This result provides support to the view that potential conflicts of interests between shareholders and debtholders over risk affect managerial compensation (John and John 1993). Finally, we find that banks with larger fractions of noninterest incomes provide CEOs with stronger risktaking incentives.…”

“…7 We expect a positive relationship between SIZE and VEGA. John and John (1993) argue that the optimal compensation structure for a manager depends not only on the conflicts of interests between shareholders and the manager, but also on the conflicts of interests between shareholders and debtholders. Before a firm issues a large amount of debt, shareholders can provide the manager with weaker risk-taking incentives.…”

Managerial Compensation and Corporate Bond Yield with Active Shareholders

“…In the case of a single project this assumption is neutral, while it is crucial for the results in the case of two projects. One possible effect of a different seniority in the ordering of repayment of managerial bonuses is that managers could be punished not only when shirking, but also when the firm is unable to repay bondholders (see for instance John and John, 1993;and Calcagno and Renneboog, 2007). The optimal priority of claims is out of the scope of this paper and requires further investigation.…”

“…This paper shares with others (e.g., John & John, 1993) the implication that managerial compensation and financial structure of the firm are to be studied together. This implication finds empirical support in Hartzell and Starcks (2003).…”

“…The research outlined in this paper relates to the literature on managerial compensation and financial structure of the firm (John & John, 1993;Berkovitz et al, 2000;Dessi, 2001;Calcagno & Renneboog, 2007). There the focus is on asset substitution efforts of insiders, while we focus on the monitoring effort of the owner.…”