Optimal Inside Debt Compensation and the Value of Equity and Debt
46 Pages Posted: 3 Dec 2013 Last revised: 28 Apr 2015
Date Written: April 27, 2015
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: Suggested Citation