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CEO tenure and cost of debt

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Abstract

In this study, we investigate the relationship between CEO tenure and cost of debt. Using a sample of the FTSE All-Share Index firms listed on the London Stock Exchange for the period 2009 to 2018 and the ordinary least squares regression (OLS) estimation method, we find that cost of debt is higher for firms with CEOs in their early tenure in office than those in their later tenure in office. Further analysis shows that board independence attributes including (1) the proportion of independent directors on the board, (2) full (100%) independent audit committee members, and (3) a lead independent director representation on the board interact with CEO early tenure in office to reduce cost of debt due to the board’s effective monitoring ability when the CEO is new and risk-seeking. Our study extends CEO tenure and corporate outcomes in general and in particular CEO risk-taking incentives and cost of debt literature, and has important implications for firms seeking to raise finance from the debt market when their CEO is new as well as identifying the control mechanisms that they need to put in place to lower the cost of debt.

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Notes

  1. More broadly, DeFusco et al. (1990) report a negative reaction of bond price following the announcement of the adoption of managerial stock option plan. Ortiz-Molina (2006) also documents a positive association between managerial ownership and borrowing costs, and that stock options held by the firm’s top five managers have a larger effect on cost of debt than stock ownership has. Similarly, while Billett et al. (2010) document a positive (negative) market reaction to delta (vega) following the first-time award of stock options to CEOs, Knopf et al. (2002) report a positive impact of the number of shares held by the CEO on derivatives but their subsequent findings suggest a negative (positive) impact of CEO vega (delta) on derivatives.

  2. The board independence attributes we consider in this study include the proportion of independent directors on the board, full (i.e. 100%) independent audit committee members, and a lead independent director representation on the board.

  3. It is important to highlight that a lead independent director representation on the board—has surprisingly not been tested on managerial risk-taking or cost of debt. However, previous literature suggests that a lead independent director representation on the board improves board monitoring (Chen and Ma 2017) and investment efficiency (Rajkovic 2020). Therefore, we include a lead independent director representation on the board in our board independence attributes analysis.

  4. In this study, we select board independence attributes as effective monitoring mechanisms because the existing literature has found them to improve corporate governance quality (Chen and Ma 2017) and, therefore, they are more likely to restrict risk-taking behaviour during the CEO’s career cycle and reduce cost of debt.

  5. Shaw (2012) also finds competing results when the sensitivities of CEO stock and option compensation portfolios to stock price (delta) and stock return (vega) volatility are used to proxy CEO risk-taking incentives.

  6. Even though our study period is restricted from 2009 to 2018 due to CEO tenure and cost of debt data availability from the Bloomberg terminal, the 10-year period is a suitably long and sustained period to investigate this important and interesting topic.

  7. In calculating the cost of debt, Bloomberg use the debt adjustment factor that captures the average yield spread between corporate bonds for a given credit class and the government bonds.

  8. We employ the first 3 years of a firm’s CEO in office to proxy CEO early tenure because it is well documented in the existing literature (e.g., Ali and Zhang 2015; Mitra et al. 2020) that CEOs are likely to engage in very risky operations during this period of their career cycle than in their later years in office and debtholders are likely to factor this period in when determining their risk premium. Hence, we define CEO’s early tenure to capture the first three years in office.

  9. The components of the CEO compensation include salary, bonus, pension, and other awards (but excluding share options).

  10. Although our sample size reduced to 2033 firm-year observations for CAPEX and 1988 firm-year observations for R&D when missing values are not coded as zero, our results (untabulated) from these reduced samples are qualitatively similar to the main results reported in Table 3.

  11. The results (untabulated) from further test for differences between firms with CEOs in their early tenure in office and those in their final year in office are qualitatively similar to the reported results under Panel B of Table 1.

  12. Chen et al. (2016) argue in their study that the industry average of the CEO tenure from the previous year may affect a firm’s CEO tenure but it is not likely to be related to the outcome variable. We follow a similar assumption and use CEOTenure_INDAVG as our instrumental variable.

  13. In our second approach of addressing endogeneity, we could not find any valid instrument for the interaction terms (i.e. CEO tenure and the board independent attributes) and, therefore, we use other governance controls to further check the robustness of our results in Sect. 6.1.

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Authors and Affiliations

  1. School of Economics, Finance and Accounting & Centre for Financial and Corporate Integrity, Coventry University, Coventry, CV1 5FB, UK

    Andrews Owusu

  2. Leicester Castle Business School, De Montfort University, Leicester, LE1 9BH, UK

    Frank Kwabi

  3. Department of Accounting, Finance and Banking, Manchester Metropolitan University, Manchester, M15 6BH, UK

    Ernest Ezeani

  4. Centre for Financial and Corporate Integrity, Coventry University, Coventry, CV1 5DL, UK

    Ruth Owusu-Mensah

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  1. Andrews Owusu
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  4. Ruth Owusu-Mensah
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Correspondence to Andrews Owusu.

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Appendices

Appendix 1

See Table 10.

Table 10 Alternative measure of CEO final year in office
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Appendix 2

See Table 11.

Table 11 Controlling for firm-level fixed effects
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Appendix 3

See Table 12.

Table 12 Controlling for institutional ownership
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Owusu, A., Kwabi, F., Ezeani, E. et al. CEO tenure and cost of debt. Rev Quant Finan Acc 59, 507–544 (2022). https://doi.org/10.1007/s11156-022-01050-2

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