London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)
Peking University - Department of Finance
June 29, 2011
Review of Finance, Vol. 15, No. 1, pp. 75-102, January 2011
EFA 2007 Ljubljana Meetings Paper
Existing theories advocate the exclusive use of equity-like instruments in executive compensation. However, recent empirical studies document the prevalence of debt-like instruments such as pensions. This paper justifies the use of debt as efficient compensation. Inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses and salaries proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also firm value in bankruptcy. Contrary to intuition, granting the manager equal proportions of debt and equity is typically inefficient. In most cases, an equity bias is desired to induce effort. However, if effort is productive in increasing liquidation value, or if bankruptcy is likely, a debt bias can improve effort as well as deter risk shifting. The model generates a number of empirical predictions consistent with recent evidence.
Number of Pages in PDF File: 27
Keywords: Agency costs of debt, asset substitution, risk shifting, executive compensation, pensions
JEL Classification: G32, G34, J33
Date posted: July 21, 2005 ; Last revised: December 7, 2011
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