Optimal Inside Debt Compensation and the Value of Equity and Debt

46 Pages Posted: 3 Dec 2013 Last revised: 28 Apr 2015

See all articles by T. Colin Campbell

T. Colin Campbell

University of Cincinnati - Department of Finance - Real Estate

Neal Galpin

Monash University - Department of Banking and Finance

Shane A. Johnson

Texas A&M University - Department of Finance

Date Written: April 27, 2015

Abstract

We study the effect of changes in CEO inside debt on equity and debt values during the period in which firms’ disclosure of inside debt increased. We predict optimal CEO relative debt-equity incentive ratios based on firm and CEO characteristics, and show that firms adjust their ratios towards the predicted optimums. Equity values rise for firms that adjust their ratios downward to their predicted optimums and for firms that adjust ratios upward toward their predicted optimums, which implies that some ratios were too low and others were too high. Debt values rise for firms that adjust their ratios upward and do not fall for those that adjust their ratios downward. Our predicted optimum explains changes in equity and debt values better than a simple and intuitive target where inside debt-equity ratios are set equal to firm debt-equity ratios. The results support an optimal contracting view of CEO inside debt and suggest important cross-sectional differences in firms’ optimal use of inside debt in compensation policies.

Keywords: Inside debt, pensions, executive compensation, incentives

JEL Classification: G14, G32, M52

Suggested Citation

Campbell, Timothy Colin and Galpin, Neal E. and Johnson, Shane A., Optimal Inside Debt Compensation and the Value of Equity and Debt (April 27, 2015). Available at SSRN: https://ssrn.com/abstract=2362480 or http://dx.doi.org/10.2139/ssrn.2362480

Timothy Colin Campbell

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business Administration
Cincinnati, OH 45221
United States

Neal E. Galpin

Monash University - Department of Banking and Finance ( email )

Melbourne
Australia

Shane A. Johnson (Contact Author)

Texas A&M University - Department of Finance ( email )

Mays School of Business
College Station, TX 77843-4218
United States
979-862-3318 (Phone)

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