Management Risk and the Cost of Borrowing

Abstract

Management risk occurs because uncertainty about future managerial decisions increases a firm’s overall risk. This paper documents the importance of management risk in determining firms’ cost of borrowing. CDS spreads, loan spreads and bond yield spreads all increase at the time of CEO turnover, when management risk is highest, and decline over the first three years of CEO tenure, regardless of the reason for the turnover. Similar but smaller patterns occur around CFO turnovers. The increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of prior uncertainty about the new management. In response to these short-term increases in borrowing costs early in their CEOs’ tenure, firms adjust their propensities to issue external debt, precautionary cash holding, and reliance on internal funds. All of these results suggest that management risk appears to be an important factor in the pricing of corporate debt.

Keywords: CEO turnover, CEO tenure, CFO, exogenous turnover, cost of borrowing, loan spread, bond yield spread, CDS spread, financial policy

JEL Classification: G32, G34, M12, M51