CEO inside debt and internal capital market efficiency

Abstract

Agency theory argues that managerial equity-based incentives are more effective when firm solvency is likely while debt-based incentives are more effective when firms face a greater likelihood of bankruptcy. We examine the relation between chief executive officers' (CEOs') inside debt holdings and the internal capital market allocation of multi-segment firms. We find that CEO inside debt holdings are associated with conservative capital allocation to firm segments, with the result driven by financially distressed firms. Further analysis indicates that although CEO inside debt, on average, is negatively related to firm value, the relation is positive for financially distressed firms. Our evidence indicates that inside debt holdings align the interests of managers and external creditors, inducing managers to pursue conservative capital allocation strategies that appear to be optimal for firms facing insolvency.