The Use of Cash Flows Metrics in CEO Compensation and the Design of Loan Contracts

78 Pages Posted: 8 Jul 2021 Last revised: 16 Dec 2022

See all articles by Guojin Gong

Guojin Gong

University of Connecticut

Daniel Jiang

University of Waterloo - School of Accounting and Finance

Biqin Xie

Office of Financial Research, U.S. Department of the Treasury

Date Written: June 14, 2024

Abstract

This study examines whether the use of cash-flow-based performance metrics (CFM) in CEO compensation contracts affects the design of loan contracts. Cash-flow-based performance evaluation explicitly motivates the CEO to improve firm's cash flows, which may enhance debt repayment ability and reduce credit risk. We thus hypothesize that lenders, anticipating this incentive effect, offer lower loan spreads and reduce the use of cash-flow-based performance covenants when firms use CFM in CEO compensation contracts. Consistent with our expectation, the use of CFM is associated with lower loan spreads and less use of cash-flow-based performance covenants. These findings remain robust after we account for endogeneity. Furthermore, these results are more pronounced in firms with higher credit risk or higher risk of cash flow shortfalls, which suggests that lenders consider internally generated cash flows more valuable when borrowers face higher external financing costs or have greater liquidity concerns. Additionally, we find that the use of CFM is associated with improved cash flow performance and enhanced creditworthiness, which supports the notion that CFM serve as an effective incentive mechanism. Overall, our evidence suggests that lenders consider the incentive effect of cash-flow-based performance evaluation in the debt contracting process.

Keywords: Executive compensation, cash-flow-based performance evaluation, agency cost of debt, loan contract design, loan spread, cash-flow-based covenant

JEL Classification: G21, G30, M12, M41, M52

Suggested Citation

Gong, Guojin and Jiang, Xin and Xie, Biqin, The Use of Cash Flows Metrics in CEO Compensation and the Design of Loan Contracts (June 14, 2024). Available at SSRN: https://ssrn.com/abstract=3879942 or http://dx.doi.org/10.2139/ssrn.3879942

Guojin Gong

University of Connecticut ( email )

Storrs, CT 06269
United States

Xin Jiang (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

Biqin Xie

Office of Financial Research, U.S. Department of the Treasury ( email )

717 14th St NW
Washington, DC 20005
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
93
Abstract Views
765
Rank
573,858
PlumX Metrics