Executive compensation and capital structure

Abstract

ABSTRACTWe examine the relation between capital structure decision and the incentive power of executive compensation that contains both cash and equity components. Our analytical model shows that executive compensation motivates CEOs to pursue more aggressive capital structure policy. However, as firm leverage reaches a certain level, further incentive from compensation cannot motivate CEOs to borrow more. Our findings thus provide an explanation to the mixed evidence of the relation documented in the literature by showing that the relation also depends on the level of firm leverage. Our empirical analysis confirms the predictions of our model that executive compensation provides strong incentive for CEOs to choose high firm leverage. However, firms with high leverage tend to offer CEO compensation with lower incentive power. Subperiod analysis shows that the magnitude of the relation changes with time, while the nature of the relation still holds over the subsample periods. Also, the relation changes with the level of leverage. It is positive when firm leverage is high, but it becomes negative when firm leverage is low.