Are Debt and Incentive Compensation Substitutes in Controlling the Free Cash Flow Agency Problem?

Abstract

This paper investigates the governance implications of a firm's capital structure and managerial incentive compensation and the substitutability of these two mechanisms in controlling the free cash flow agency problem. The study is designed to explore the different ways that debt and incentives work on the agency problem. Debt directly restricts the investment scale while incentive compensation makes investment less sensitive to free cash flow. The substitutability of debt and incentive compensation and the potential endogeneity of investment, capital structure and compensation are examined by estimating a nonlinear simultaneous equations system. The results suggest: (1) Debt and executive stock options act as substitutes in attenuating a firm's free cash flow problem, which provides a partial answer to the puzzle as to why some firms predominantly grant options but issue little debt despite their excess debt capacity. (2) Failure to incorporate the substitutability and endogeneity of capital structure and incentive compensation leads to underestimates of the magnitude and economic implication of their capital structure and compensation structure to control for overinvestment. (4) Firm characteristics differ across the prevalence of debt usage versus option usage, suggesting the heterogeneity in the costs and benefits of the monitoring devices. (5) All the above effects are more prominent in firms that tend to have more severe free cash flow problems.