CEO's Inside Debt and Dynamics of Capital Structure

Abstract

Debt-type compensation (i.e., inside debt) exacerbates the divergence in risk preference between the CEO and shareholders that in turn affects the firm’s capital structure decisions. An excessively risk-averse CEO uses debt that falls short of the shareholders’ desired level, and is eager to lower the debt ratio when the firm is over-levered but reluctant to enhance the debt ratio when the firm is under-levered. We find that higher CEO inside debt ratio is associated with lower firm debt ratio and faster (slower) leverage adjustments toward the shareholders’ desired level for over-levered (under-levered) firms. The CEO inside debt ratio most conducive to optimal capital structure dynamics is around 10 percent of the firm’s market debt ratio.

Keywords: inside debt, capital structure, shareholders’ desired leverage, speed of adjustment (SOA), managerial conservatism, risk-shifting

JEL Classification: G30, G32, G34