Executive Compensation and Debt - An Investigation of Investment Decisions

Abstract

We investigate the role of debt in solving agency problems by proposing a theoretical model that allows firms to choose from three investment opportunities, namely, zero risk, low risk and high risk. The theoretical model shows that a nonlinear relation potentially exists between debt and the pay-for-performance sensitivity of the executive compensation contract. The nonlinearity is driven by the firm’s risk preference which is reflected in its strategic orientation. The validity of the theoretical model is examined empirically by estimating a panel threshold regression model, whose functional form can be derived directly from the theoretical framework. We use a sample of S&P1500 firms over the period 1992-2013. Empirical tests confirm that debt affects the pay-for-performance sensitivity of the executive compensation contract differently, depending on the firm’s risk preference.