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
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: Suggested Citation