Risk-Adjusted Inside Debt

Abstract

Compensation theory holds that executive aggression is related to both the level and riskiness of inside debt. However, previous researchers only have examined the level of inside debt. We provide an inside debt metric that is conceptually superior to previously used metrics as it incorporates the riskiness of inside debt. For the overall sample, our metric provides similar fit to prior metrics but is theoretically superior. The relation between our risk-adjusted inside debt metric and corporate conservatism is modestly better for non-investment grade firms, firms experiencing credit rating downgrades, and firms with high credit risk. The results tentatively support that managers are concerned with the risk-adjusted value of their inside debt, i.e., the inside debt adjusted by its default probability and expected recovery rate. Based on our findings for U.S. firms, we expect our metric to offer more explanatory power for economies wherein inside debt is very risky.