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Review of Quantitative Finance and Accounting

Erschienen in:

01.04.2012 | Original Research

CEO incentives and the cost of debt

verfasst von: Kenneth W. Shaw

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 3/2012

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Abstract

Motivated by concerns that stock-based compensation might lead to excessive risk-taking, this paper’s main purpose is to examine the relations between CEO incentives and the cost of debt. Unlike prior research, this paper uses the sensitivities of CEO stock and option portfolios to stock price (delta) and stock return volatility (vega) to measure CEO incentives to invest in risky projects. Higher delta (vega) is predicted to be related to lower (higher) cost of debt. The results show that yield spreads on new debt issues are lower for firms with higher CEO delta and are unrelated to CEO vega. The results also show that yield spreads are higher for firms whose CEOs hold more shares and stock options. In sum, the results suggest that both percentage-ownership and option sensitivity variables are important in understanding relations between CEO incentives and the cost of debt.

Vorheriger Artikel CEO stock options and analysts’ forecast accuracy and bias

Nächster Artikel The makings of an information leader: the intraday price discovery process for individual stocks in the DJIA

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Sensitivity to return volatility (stock price) is also commonly referred to as vega (delta).

These results are most pronounced for firms with relatively low levels of managerial share ownership.

Other studies that use the Core–Guay (2002) approximation include Cao and Laksmana (2010), Knopf et al. (2002), Rajgopal and Shevlin (2002), Bergstresser and Philippon (2006), Billett et al. (2010), Cheng and Warfield (2005), Burns and Kedia (2006), Erickson et al. (2006), and Hanlon et al. (2004).

Firms without options held by their CEO’s are excluded from the sample.

The regressions (see Sect. 4) use lagged values of certain independent variables. Since Execucomp data begin in 1992, 1993 is the first year of debt issue data applicable.

Some firms have more than one debt issue during a year. Sensitivity tests using either a weighted-average yield spread across all of a firm’s debt issues during a year or the largest (dollars of proceeds) issue of the year yield results similar to those reported in the paper.

Some research uses the firm’s overall credit rating, rather than the credit rating on the new issue (e.g. Ashbaugh-Skaife et al. 2006). I do not study this measure as evidence in Holthausen and Leftwich (1986) suggests these credit ratings are subject to rigorous analysis only at the time of a new issue or around special events; thus, these ratings tend to be sticky. Further, firm-level credit ratings are less likely to reflect issue-specific features, like covenants, that protect debt investors.

Guay (1999) provides a method of measuring the impact of small changes in stock price volatility on the value of CEO shareholdings. His results suggest this effect is immaterial, and like other studies I do not include an estimate of the effect of volatility on CEO shareholdings in my measure of vega.

Consistent with Coles et al. (2006), untabulated analyses show that VEGA is positively related to R&D expenditures and inversely related to capital expenditures, suggesting that VEGA is related to the riskiness of investment projects for this paper’s sample.

Results are similar if concentrated ownership is defined instead as the percentage of outstanding shares owned by blockholders holding at least 5 percent of the firm’s outstanding shares.

Along similar lines, Nagata and Hachiya (2007) find that firms with more conservative earnings management have higher initial offering prices.

This sample includes debt rated as AAA, AA+, AA, AA−, A+, A, A−, BBB+, BBB, BBB−, BB+, BB, BB−, B+, B, and B−.

Some studies control for the presence of subordinated debt. Less than three percent of the debt issuances in this study are for subordinated debt. Including an indicator variable for subordinated debt does not qualitatively impact this study’s inferences.

Data to compute these measures are from Compustat. Market value of assets is defined as the book value of debt plus the market value of equity.

Studying a broad cross-section of industries, Core and Guay (2002) report a median of $28 million for option sensitivity to return volatility.

Shi (2003), Bhojraj and Sengupta (2003), Anderson et al. (2004), and Klock et al. (2005) report median yield spreads of 78, 93, 103, and 143 respectively.

Ortiz-Molina (2006), Anderson et al. (2003), and Klock et al. (2005) follow a similar approach.

The (untabulated) estimated equation is RATING = 10.090 +1.261*OPT +0.086*STK − 0.543*LDELTA − 0.210*LVEGA. The coefficients on OPT, STK, and LDELTA are each significant at p < 0.01. The coefficient on LVEGA is not significant at conventional levels (p = 0.14).

SIC codes 9000 and above and year 2004 are captured in the intercept.

Coefficients on the industry (IND) and year (YR) indicator variables are not tabulated for brevity. p-values reported in the paper are for one-tailed tests where coefficient signs are predicted, and for two-tailed tests where coefficient signs are not predicted.

Results of untabulated regressions suggest credit ratings explain a large portion of the variation in yield spreads, thus usurping some of the potential explanatory power of the other control variables.

Results on the earnings timeliness and accruals quality variables are consistent with Crabtree and Maher (2005), who find earnings predictability is related to better credit ratings and lower yield spreads on new issues.

For example, less risky firms (with lower-cost debt) might increase delta to encourage CEO risk-taking Ortiz-Molina (2007) finds that the relation between the change in CEO wealth and current stock return decreases in straight-debt leverage and increases with convertible-debt leverage. This suggests CEO pay-performance sensitivity is related to capital structure.

The residual credit rating variable (RES_RATING _i,t) is excluded from the regression with Rating _i,t as the dependent variable.

Anderson et al. (2003) show that founding family ownership is associated with lower yield spreads. Execucomp does not identify founders, and identifying firms with founding family owners involves non-trivial manual data collection. However, as noted by Baker and Hall (2002), CEOs rarely hold more than 5 percent of the company’s shares unless they are founders. Results are not sensitive to dropping firms with CEO ownership greater than 5 percent.

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Titel: CEO incentives and the cost of debt
verfasst von: Kenneth W. Shaw
Publikationsdatum: 01.04.2012
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 3/2012
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-011-0230-7

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