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Inside Debt

Review of Finance, Vol. 15, No. 1, pp. 75-102, January 2011

EFA 2007 Ljubljana Meetings Paper

27 Pages Posted: 21 Jul 2005 Last revised: 7 Dec 2011

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Qi Liu

Peking University - Department of Finance

Date Written: June 29, 2011

Abstract

Existing theories advocate the exclusive use of equity-like instruments in executive compensation. However, recent empirical studies document the prevalence of debt-like instruments such as pensions. This paper justifies the use of debt as efficient compensation. Inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses and salaries proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also firm value in bankruptcy. Contrary to intuition, granting the manager equal proportions of debt and equity is typically inefficient. In most cases, an equity bias is desired to induce effort. However, if effort is productive in increasing liquidation value, or if bankruptcy is likely, a debt bias can improve effort as well as deter risk shifting. The model generates a number of empirical predictions consistent with recent evidence.

Keywords: Agency costs of debt, asset substitution, risk shifting, executive compensation, pensions

JEL Classification: G32, G34, J33

Suggested Citation

Edmans, Alex and Liu, Qi, Inside Debt (June 29, 2011). Review of Finance, Vol. 15, No. 1, pp. 75-102, January 2011; EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=758508

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Qi Liu

Peking University - Department of Finance ( email )

Beijing
China

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