Does CEO inside debt compensation benefit both shareholders and debtholders?

Abstract

We examine whether the proportion of CEO inside debt holdings (pension and deferred compensation) to stock holdings benefit both shareholders and debtholders by relating CEO inside debt to a firm’s dividend payout policies. Based on the positive association of CEO inside debt and the propensity and the size of the dividend payout, we find that firms paying their CEOs with large inside debt present the lower cost of debt and default risk, and these benefits transfer to better firm performance and valuation. Moreover, we find that CEO inside debt is related to superior firm performance only in dividend-paying firms. Dividends tend to increase when firms with high agency costs of equity use inside debt. We conclude that dividends serve as a channel through which CEO inside debt compensation mitigates both agency costs of debt and agency costs of equity.

Appendices

Appendix 1

See Table 12.

Table 12 Definitions of variables

Appendix 2

KMV–Merton model to estimate probability of default.

The KMV–Merton model translates the value and the volatility of a firm’s equity into an implied probability of default. The value of the firm’s equity is as follows:

$$E = VN\left( {d_{1} } \right) - e^{ - rT} FN\left( {d_{2} } \right),$$

(1)

where $d_{1} = \frac{{\ln \left( {\frac{V}{F}} \right) + \left( {r + 0.5\sigma_{v}^{2} } \right)T}}{{\sigma_{v} \sqrt T }}$, $d_{2} = d_{1} - \sigma_{v} \sqrt T ,$ V is the total value of the firm, E is the market value of the firm’s equity, F if the face value of the firm’s debt, r is the risk-free rate, $\sigma_{v}$ is the volatility of firm value, T if the time to maturity, and N(.) is the cumulative standard normal distribution function.

The volatility of the firm’s equity is as follows:

$$\sigma_{E} = \left( {\frac{V}{E}} \right)N\left( {d_{1} } \right)\sigma_{ v}$$

(2)

where $\sigma_{E}$ is the volatility of firm equity, and other variables are defined in Eq. (1).

After simultaneously solve Eqs. (1) and (2) for the firm value and firm value volatility, the distance to default can be calculated as follows:

$$DD = \frac{{\ln \left( {\frac{V}{F}} \right) + \left( {\mu - 0.5\sigma_{v}^{2} } \right)T}}{{\sigma_{v} \sqrt T }},$$

where µ is an estimate of the expected annual return of the firm’s assets. The corresponding estimated probability of default is as follows:

$${\text{Probability}}\,{\text{of}}\,{\text{default}}\, = \,{\text{N}}( - DD) = N\left( {\frac{{\ln \left( {\frac{V}{F}} \right) + \left( {\mu - 0.5\sigma_{v}^{2} } \right)T}}{{\sigma_{v} \sqrt T }}} \right),$$

where N(.) is the cumulative standard normal distribution function.