Abstract
Recent studies argue that CEO option compensation affects executives’ behavior toward risk. Specifically, the literature provides seemingly conflicting evidence regarding the impact of equity compensation (particularly option holding) on financing activities. We propose and test a nonlinear (e.g., inverted U-shaped) relation between corporate borrowing and option compensation. Consistent with our hypothesis, we empirically show that, in the low range of the option vega, a firm’s debt ratio increases as the option vega increases. However, in the high range of the option vega, we find the opposite relation. Our explanation is based on the contrasting effects of option compensation on managerial incentives toward risk. The positive wealth effect on leverage arises from the convexity of the option compensation, while a negative risk-premium effect exists due to managerial risk aversion. This reconciles the conflicting relation between leverage and option compensation that is often observed in the literature.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Guay (1999) provides evidence that stock options significantly increase the convexity of the relation between managers’ wealth and stock price. We use a firm’s option vega to measure option convexity as in Guay (1999). The option vega is defined as the change in the manager’s option value for a given change in the value of stock return volatility.
The financial crisis of 2008–2009 has triggered an interesting recent literature that examines the relation between executive compensation structures and risk-taking behavior in the financial industry. Refer to Bhagat and Bolton (2014), Minhat and Abdullah (2016), and Gande and Kalpathy (2017). Also refer to Malmendier and Tate (2005) and Yung and Chen (2018) for empirical evidence of the relation between risk-taking investment and CEO characteristics such as confidence and ability.
It is well recognized in the literature that expected wealth increases with risk when a CEO’s stock-based compensation is convex. Refer to Jensen and Meckling (1976), Haugen and Senbet (1981), and Guay (1999), among others. Since the CEO faces a risky payoff from the incentive compensation, s/he demands a risk premium. Lewellen (2006) also recognizes the wealth benefit and volatility cost (due to the manager’s risk aversion) of option compensation. See Lambert et al. (1991), Carpenter (2000), Hall and Murphy (2002), and Ross (2004) for further review regarding the importance of risk aversion on the part of managers.
Lewellen (2006) argues that CEOs may have discretion over a firm’s capital structure because of imperfections in corporate governance, which motivates the inclusion of corporate governance variables as control variables. In fact, our results show significant impacts of some governance variables, such as CEO tenure, board independence, and board size.
Jiraporn and Chintrakarn (2013) also employ a second-order polynomial regression to check the inverted-U shaped relation between CEO pay slices and corporate social responsibility.
We recognize some attempts to minimize the endogeneity issue by examining the exogenous impact of CEO compensation on risk-taking behavior. For example, Hayes et al. (2012) examine the link between option compensation and risk-taking behavior by using Financial Accounting Standards (FAS) 123R and the change in accounting treatment of options. They do not find a strong relation between the option pay and risky investments. More recently, Tosun (2016) employs the Internal Revenue Code 162 tax law as an exogenous shock to compensation structure to consider firm leverage changes as a result of CEO option compensation changes.
We also employed firm fixed-effects regression and found insignificant results. The fixed-effects regression assumes that there is sufficient time variation in the option vega within firms. Similar to Coles et al. (2006) and Zhou (2001), we attribute the insignificant result in the firm fixed-effects analysis to the lack of variation in our sample’s option vega over time within firms.
We appreciate an anonymous referee for bringing up this excellent idea.
References
Aggarwal RK, Samwick AA (1999) Executive compensation, strategic competition, and relative performance evaluation: theory and evidence. J Finance 54:1999–2043. https://doi.org/10.1111/0022-1082.00180
Agrawal A, Mandelker GN (1987) Managerial incentives and corporate investment and financing decisions. J Finance 42:823–837. https://doi.org/10.1111/j.1540-6261.1987.tb03914.x
Angrist JD, Pischke JS (2008) Mostly harmless econometrics: an empiricist's companion. Princeton University Press, Princeton
Bhagat S, Bolton B (2014) Financial crisis and bank executive incentive compensation. J Corp Finance 25:313–341. https://doi.org/10.1016/j.jcorpfin.2014.01.002
Campbell TC, Gallmeyer M, Johnson SA, Rutherford J, Stanley BW (2011) CEO optimism and forced turnover. J Financ Econ 101:695–712. https://doi.org/10.1016/j.jfineco.2011.03.004
Carpenter JN (2000) Does option compensation increase managerial risk appetite? J Finance 55:2311–2331. https://doi.org/10.1111/0022-1082.00288
Chava S, Purnanandam A (2010) CEOs versus CFOs: incentives and corporate policies. J Financ Econ 97:263–278. https://doi.org/10.1016/j.jfineco.2010.03.018
Coles JL, Daniel ND, Naveen L (2006) Managerial incentives and risk-taking. J Financ Econ 79:431–468. https://doi.org/10.1016/j.jfineco.2004.09.004
Core J, Guay W (2002) Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. J Account Res 40:613–630. https://doi.org/10.1111/1475-679X.00064
Gande A, Kalpathy S (2017) CEO compensation and risk-taking at financial firms: evidence from U.S. federal loan assistance. J Corp Finance 47:131–150. https://doi.org/10.1016/j.jcorpfin.2017.09.001
Guay WR (1999) The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants. J Financ Econ 53:43–71. https://doi.org/10.1016/S0304-405X(99)00016-1
Hall BJ, Liebman JB (1998) Are CEOs really paid like bureaucrats? Q J Econ 113:653–691. https://doi.org/10.1162/003355398555702
Hall BJ, Murphy KJ (2002) Stock options for undiversified executives. J Account Econ 33:3–42. https://doi.org/10.1016/S0165-4101(01)00050-7
Haugen RA, Senbet LW (1981) Resolving the agency problems of external capital through options. J Finance 36:629–647. https://doi.org/10.1111/j.1540-6261.1981.tb00649.x
Hayes RM, Lemmon M, Qiu M (2012) Stock options and managerial incentives for risk-taking evidence from FAS 123R. J Financ Econ 105:174–190. https://doi.org/10.1016/j.jfineco.2012.01.004
Iqbal J, Vähämaa S (2019) Managerial risk-taking incentives and the systemic risk of financial institutions. Rev Quant Financ Account 53:1229–1258. https://doi.org/10.1007/s11156-018-0780-z
Jensen MC, Meckling WH (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. J Financ Econ 3:305–360. https://doi.org/10.1016/0304-405X(76)90026-X
Jiraporn P, Chintrakarn P (2013) How do powerful CEOs view corporate social responsibility (CSR)? An empirical note. Econ Lett 119:344–347. https://doi.org/10.1016/j.econlet.2013.03.026
Kim K, Patro S, Pereira R (2017) Option incentives, leverage, and risk-taking. J Corp Finance 43:1–18. https://doi.org/10.1016/j.jcorpfin.2016.12.003
Lambert RA, Larcker DF, Verrecchia RE (1991) Portfolio considerations in valuing executive compensation. J Account Res 29:129–149. https://doi.org/10.2307/2491032
Lewellen K (2006) Financing decisions when managers are risk averse. J Financ Econ 82:551–589. https://doi.org/10.1016/j.jfineco.2005.06.009
MacKie-Mason JK (1990) Do taxes affect corporate financing decisions? J Finance 45:1471–1493. https://doi.org/10.1111/j.1540-6261.1990.tb03724.x
Malmendier U, Tate G (2005) CEO overconfidence and corporate investment. J Finance 60:2661–2700. https://doi.org/10.1111/j.1540-6261.2005.00813.x
Mehran H (1992) Executive incentive plans, corporate control, and capital structure. J Financ Quant Anal 27:539–560. https://doi.org/10.2307/2331139
Minhat M, Abdullah M (2016) Bankers’ stock options, risk-taking and the financial crisis. J Financ Stab 22:121–128. https://doi.org/10.1016/j.jfs.2016.01.008
Pratt JW (1964) Risk aversion in the large and in the small. Econometrica 32:122–136
Ross SA (2004) Compensation, incentives, and the duality of risk aversion and riskiness. J Finance 59:207–225. https://doi.org/10.1111/j.1540-6261.2004.00631.x
Tosun OK (2016) The effect of CEO option compensation on the capital structure: a natural experiment. Financ Manag 45:95–979. https://doi.org/10.1111/fma.12116
Yermack DL (1995) Do corporations award CEO stock options effectively? J Financ Econ 39:237–269. https://doi.org/10.1016/0304-405X(95)00829-4
Yung K, Chen C (2018) Managerial ability and firm risk-taking behavior. Rev Quant Financ Account 51:1005–1032. https://doi.org/10.1007/s11156-017-0695-0
Zhou X (2001) Understanding the determinants of managerial ownership and the link between ownership and performance: comment. J Financ Econ 62:559–571. https://doi.org/10.1016/S0304-405X(01)00085-X
Acknowledgements
We appreciate valuable feedback and encouragement from Catherine Choi, David Emmanuel, Vladimir Gatchev, Sulei Han, and Sangwon Lee. The guidance and feedback from Cheng-few Lee (Editor) and an anonymous referee were instrumental in significantly improving this manuscript. We also acknowledge that this work was supported by Global Research Network program through the Ministry of Education of the Republic of Korea and the National Research Foundation of Korea (NRF-2016S1A2A2912421).
Author information
Authors and Affiliations
Corresponding author
Ethics declarations
Conflict of interest
The authors declare that they have no conflict of interest.
Additional information
Publisher's Note
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
Appendix: Definitions of variables
Appendix: Definitions of variables
Variable name | Description |
|---|---|
Vega | The sensitivity of the manager’s wealth to the firm’s stock return volatility as defined in Coles et al. (2006) |
Ln(1 + Vega) | The natural logarithm of (1 + vega of CEOs’ compensation) |
Delta | The sensitivity of the manager’s wealth to the firm’s stock price as defined in Coles et al. (2006) |
Ln(1 + Delta) | The natural logarithm of (1 + delta of CEOs’ compensation) |
Leverage | The ratio of total debt (debt in current liabilities + long-term debt) to total assets |
Asset | The natural log of assets |
MTB | The ratio of market value (book value of assets—less the book value of equity + the market value of equity) to total assets |
NWC | The ratio of net working capital to the total assets |
CAPX | The ratio of Capital investment (capital expenditures – sale of property) to total assets |
R&D | The ratio of R&D investment (research and development expense) to total assets |
Z-score | The modified z-score as defined in 1990 and is equal to 3.3(EBIT/Total Assets) + 1.0(Sales/Total Assets) + 1.4 (Retained Earnings/Total Assets) + 1.2 (Working Capital/Total Assets) |
ROA | The ratio of net income (operating income after depreciation plus depreciation) to total assets |
Divpayer | A dummy variable that is set to the value of one if the firm paid a dividend in the year |
Tenure | The number of years the CEO has served in position at given year |
Boardsize | The natural log of number of directors sitting on the board |
Boardindep | The percentage of independent non-executive directors on the board at given year |
Rights and permissions
About this article
Cite this article
Choi, Y.K., Han, S.H. & Mun, S. The nonlinear relation between financing decisions and option compensation. Rev Quant Finan Acc 56, 1343–1356 (2021). https://doi.org/10.1007/s11156-020-00930-9
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11156-020-00930-9