Executive compensation and capital structure:

The effects of convertible debt and straight debt on CEO pay

Hernan Ortiz-Molina*

Sauder School of Business

The University of British Columbia 2053 Main Mall, Vancouver, BC, Canada V6T 1Z2

Tel: 604.822.6095, Fax: 604.822.4695 Email: ortizmolina@sauder.ubc.ca.

Forthcoming at the Journal of Accounting and Economics

Abstract I examine how CEO compensation is related to firms’ capital structures. My tests address the simultaneity of these decisions and distinguish between debt types with different theoretical implications for managerial incentives. Pay-performance sensitivity decreases in straight-debt leverage, but is higher in firms with convertible debt. Furthermore, stock option policy is the component of CEO pay that is most sensitive to differences in capital structure. The results strongly support the hypothesis that firms trade-off shareholder-manager incentive alignment in order to mitigate shareholder-bondholder conflicts of interest. The hypothesis that debt reduces manager-shareholder conflicts can explain some but not all of the results.

JEL classification: G32, G34, J33, D82. Keywords: Executive compensation; agency problems; capital structure. * This paper is derived from my doctoral dissertation at the University of Maryland. I thank especially my thesis committee, Roger Betancourt, Gordon Phillips, Nagpurnanand Prabhala, Lawrence Ausubel, and Ginger Jin. Thanks also to Samuel Berlinski, Martin Boyer, Murray Carlson, Gilles Chemla, Alan Douglas, Jerry Feltham, Adlai Fisher, Murray Frank, S.P. Kothari (the Editor), Kin Lo, an anonymous referee, and seminar participants at HEC Montréal, Tilburg University, University of British Columbia, University of Maryland, University of Warwick, Norwegian School of Management, Stockholm School of Economics, and participants at the 19th Annual Pacific Northwest Finance Conference 2003 and the Northern Finance Association Meetings 2003. I gratefully acknowledge the financial support from the Social Sciences and Humanities Research Council of Canada. A previous version of the paper circulated under the title “Does capital structure matter in setting CEO pay?”.

Executive compensation and capital structure:

The effects of convertible debt and straight debt on CEO pay

Abstract

I examine how CEO compensation is related to firms’ capital structures. My tests

address the simultaneity of these decisions and distinguish between debt types with

different theoretical implications for managerial incentives. Pay-performance

sensitivity decreases in straight-debt leverage, but is higher in firms with

convertible debt. Furthermore, stock option policy is the component of CEO pay

that is most sensitive to differences in capital structure. The results strongly support

the hypothesis that firms trade-off shareholder-manager incentive alignment in

order to mitigate shareholder-bondholder conflicts of interest. The hypothesis that

debt reduces manager-shareholder conflicts can explain some but not all of the

results.

1. Introduction Modern agency theory suggests that a firm’s financial structure can affect the

agency relationship between shareholders and managers, and also that conflicts of interest

between shareholders and bondholders can affect the provision of optimal incentives to

managers. However, assuming that capital structure is unimportant to understand how

firms set their compensation packages, studies of executive compensation typically ignore

the role of firms’ capital structures. This paper shows that capital structure matters in

setting executive pay, and sheds light on the nature of this relation.

The null hypothesis is that capital structure and CEO pay are not related. However,

these decisions are likely to be simultaneously determined, since firms can minimize the

agency costs created by managerial discretion and misaligned incentives by optimizing

jointly over capital structure and compensation decisions. Capital structure can affect CEO

compensation through two (non exclusive) channels. The agency cost of equity hypothesis

suggests that debt mitigates shareholder-manager agency problems by inducing lenders to

monitor, reducing the free cash flow available to managers, and forcing managers to focus

on value maximization when facing the threat of bankruptcy (e.g., Jensen, 1986; Grossman

and Hart, 1982). Thus, higher debt and high-powered incentives that are costly to under-

diversified managers can be substitutes, leading to lower pay-performance sensitivity in

more levered firms.

The agency cost of debt hypothesis suggests that managerial incentives are driven

by the need to mitigate not only shareholder-manager but also shareholder-bondholder

conflicts of interest (Jensen and Meckling, 1976 provide the early intuition; Brander and

Poitevin, 1992, John and John, 1993 provide formal analyses). When managerial and

shareholder interests are closely aligned, managers have incentives to choose investment

policies that benefit shareholders at the expense of bondholders. However, this creates

agency costs of debt finance because rational lenders price debt issues taking into account

managerial incentive structures. Since shareholder-bondholder conflicts are more severe in

more levered firms, these firms may find optimal to reduce agency costs of debt finance by

inducing a lower incentive alignment with their managers, even when this may increase the

agency costs of equity. Thus, the first implication of this hypothesis is also a negative

association between pay-performance sensitivity and financial leverage.

1

The agency costs of debt can also be reduced by using convertible debt, which

introduces a concave region in the payoff to levered equity and thus mitigates the asset

substitution problem (Green, 1984). Consistent with this view, several studies show that

firms with greater propensity to shift risk onto bondholders are more likely to issue

convertibles.1 Mayers (1998) also provides evidence that, when the profitability of future

investment is uncertain, convertible bonds can control the overinvestment incentives that

arise if financing precedes an investment option’s maturity. In addition, firms with

convertible debt have debt ratios that are similar to those of firms with straight debt only.

As a result, firms with convertible debt in their capital structures differ from firms with

straight debt in that they have used security design to mitigate the agency costs of debt, and

therefore may use higher pay-performance sensitivities to minimize agency costs of equity.

Thus, the second and distinct implication of the agency cost of debt hypothesis is that firms

with convertible debt will set higher pay-performance sensitivities.

This paper explores how pay-performance sensitivity and the structure of CEO

compensation packages depend on the level and composition of debt financing. By way of

a preview, my main contributions are as follows. First, my tests econometrically address

the simultaneity of CEO compensation and capital structure decisions and allow me to

make causal statements. Second, I separate convertible debt from straight debt, and thus

my tests have power to distinguish between the two alternative hypotheses. Third, I find

that capital structure matters in setting CEO pay in an economically important way. Fourth,

my findings provide strong support for the agency costs of debt hypothesis. The agency

costs of equity story can also explain some but not all of my results.

While addressing the simultaneity of compensation and capital structure decisions,

I estimate CEO pay-performance sensitivity – the sensitivity of changes in CEO firm-

specific wealth to changes in shareholder wealth – as a function of financial leverage and

the use of convertible debt. I find that pay-performance sensitivity decreases in total

leverage, which is consistent with both the agency cost of equity and the agency cost of

debt hypotheses. When I distinguish between convertible and straight debt I find further

support for the agency costs of debt story: pay-performance sensitivity decreases in

1 See, for example, Mikkelson (1981), Lewis et al. (1998, 1999), Krishnaswami and Yamar (2004), and Gomez and Phillips (2005).

2

leverage due to straight debt, but it is higher in firms with convertible debt. These effects

are economically important. Pay-performance sensitivity is $12.7 per thousand-dollar

increase in shareholder return for a CEO in an all-equity firm. In firms without convertible

debt, this figure falls to $10.0, $7.8 and $5.0 for CEOs in firms with median, 75th

percentile and 95th percentile leverage, respectively. In firms with convertible debt pay-

performance sensitivity is $5.9 higher.

If more levered firms set lower CEO pay-performance sensitivity to mitigate

shareholder-bondholder conflicts of interest regarding risk-taking, stock options that

typically provide higher risk-taking incentives than stock may play a special role. To

explore this possibility, I first split the change in CEO firm-specific wealth into its stock

and stock option components. The sensitivity of managerial wealth in options to changes in

shareholder wealth falls more rapidly as leverage increases than that of managerial wealth

in stock. Also, the share of stock options in managerial portfolios of firm stock and options

decreases in leverage. I then study how capital structure affects CEO annual pay. Pay-

performance sensitivity decreases in leverage due to straight debt, but convertible debt has

no effect. The fraction of annual pay in the form of new stock option grants decreases in

the amount of straight debt, but is higher for firms with convertible debt. In addition, CEOs

in firms with more straight debt are less likely to receive new stock option grants and more

likely to receive new shares, while those in firms with convertible debt are more likely to

receive new options. Thus, consistent with agency costs of debt arising from CEOs’ risk-

taking incentives, stock options are the component of the pay-performance relation that is

most sensitive to differences in capital structure.

While no previous work provides an in-depth study of the effect of capital structure

on CEO compensation, some studies examine the determinants of new stock and stock

option grants, and include leverage as an explanatory variable in the analysis. Lewellen et

al. (1987) find a positive effect of leverage on stock option grants, while Matsunaga

(1995), Mehran (1995), and Yermack (1995) find no effect. Bryan et al. (2000) find a

negative effect on new option grants, but a positive effect on stock grants. In addition,

Ittner et al. (2003) find that leverage reduces equity-based pay in “new economy” firms,

but not in traditional firms. Thus, the evidence from these studies relating financial

leverage and executive pay is mixed and difficult to interpret.

3

I add to this literature in several ways. First, I provide a detailed analysis of the

effect of capital structure on CEO pay. Second, since theory relates capital structure to

overall CEO incentives to maximize share prices, my measure includes managerial

holdings of previously granted stock and stock options, the primary source of incentives,

and not only new grants. Third, I explicitly address the simultaneity of capital structure and

CEO incentive structures. Thus, I establish the causality as suggested by the hypotheses

and also show that ignoring this simultaneity biases the tests towards finding no effect.

Fourth, I separate straight debt from convertible debt, which has different theoretical

implications for CEO incentives. Thus, my tests have power to distinguish the agency cost

of debt hypothesis from the agency cost of equity story. Finally, I evaluate the economic

importance of the effect of capital structure on managerial incentives.

Also related work includes Jensen et al. (1992), who examine the simultaneous

determination of financial leverage, dividend policy, and insider ownership, and Agrawal

and Knoeber (1996), who study the interaction between firm performance and alternative

mechanisms to control shareholder-manager agency problems. In contrast to my results,

both studies report no effect of leverage on managerial ownership. The negative effect of

leverage on CEO incentives I document is consistent with the results in Gilson and

Vetsuypens (1993), who find that pay-performance sensitivity is low during financial

distress, but it increases after firms restructure their debt. My results suggest that

stockholder-bondholder conflicts may help explain the low sensitivities in financially

distressed firms. Finally, John et al. (2003) examine the incentive features of management

compensation structures in the context of the unique claim structure of banks. I add to their

work by exploring the effect of capital structure on pay-performance sensitivity for non-

financial firms, where monitoring mechanisms are very different.

The article is organized as follows. Section 2 discusses the theoretical framework

and hypotheses. Section 3 describes the data. Section 4 investigates the effect of capital

structure on CEO pay-performance sensitivity. Section 5 explores how more levered firms

induce changes in CEO equity-based incentives. Section 6 reports robustness checks.

Section 7 concludes.

4

2. Theoretical framework and hypotheses tested

This section outlines the theoretical framework used to analyze the effect of capital

structure on the design of CEO compensation packages, develops the hypotheses tested,

and discusses the appropriate tests.

While the null hypothesis in this study is that financing and compensation decisions

are independent (the independence hypothesis), firms can minimize the agency costs

created by managerial discretion and misaligned incentives by optimizing jointly over

capital structure and compensation decisions. Thus, capital structure and compensation

policy are likely to be simultaneously determined and directly related through agency

theories. Three stakeholder groups are most relevant: firm managers, external shareholders,

and creditors. Capital structure could affect executive compensation practices through two

different (but non-exclusive) channels.

The agency cost of equity hypothesis suggests that financial leverage mitigates

manager-shareholder conflicts of interest. Grossman and Hart (1982) argue that since

higher debt ratios increase the threat of bankruptcy, which managers are anxious to avoid

due to the potential loss of control of their firms, increased debt induces managers to avoid

policies they might personally prefer but which reduce firm value. Jensen (1986) suggests

that the fixed payments associated with debt reduce the firm’s free cash flow, and limit

management’s ability to use corporate resources for their own benefit. In addition, the

issuance of external debt may result in monitoring by bondholders, other lenders,

investment bankers, and bond rating agencies. Debt covenants also ensure that trustees will

monitor the firm’s performance periodically. If higher debt mitigates stockholder-manager

conflicts of interest, then reliance on high-powered incentives may not be necessary. Given

that ownership is costly to insiders who must allocate a large proportion of their wealth to

the firm, and therefore hold a non-diversified portfolio, these theories suggest a negative

relation between pay-performance sensitivity and leverage.

The agency cost of debt hypothesis suggests that managerial compensation depends

not only on the shareholder-manager agency relation, but also on the need to mitigate

shareholder-bondholder conflicts of interest regarding investment policy. Conflicts of

interest arise because shareholders may have incentives to reject positive NPV projects that

benefit bondholders but reduce the value of equity (Myers, 1977), or to take high-risk

5

negative NPV projects that increase equity value but reduce bonds value (Jensen and

Meckling, 1976). In addition, these distortions in investment decisions are increasing in

leverage and can be substantial even for large, financially healthy firms (Parrino and

Weisbach, 1999).2 As Jensen and Meckling (1976) show, the extent to which managers

will act opportunistically in the interest of shareholders depends on their equity-based

incentives to maximize shareholder value. However, higher equity-based incentives create

agency costs of debt finance that are born by shareholders, as rational lenders price debt

issues taking into account the information contained in managerial incentive structures.3

Building on Jensen and Meckling’s reasoning, Brander and Poitevin (1992) and

John and John (1993) view the management contract as a tool to deal with both

shareholder-manager and shareholder-bondholder agency problems. Because the severity

of the latter problems increases in leverage, these theories suggest that shareholders in

more levered firms can reduce the agency costs of debt finance by inducing a lower

incentive alignment with their managers. That is, the optimal contract may give up some

incentive alignment with managers (at the expense of increasing the agency costs of

equity) in order to reduce agency costs of debt. Thus, the first prediction of the agency

costs of debt hypothesis is a negative relation between pay-performance sensitivity and

financial leverage. This implication is similar to that from the agency costs of equity

hypothesis.

Green (1984) shows that convertible debt introduces a concave region in the payoff

to levered equity that ameliorates risk-shifting incentives and reduces the agency costs of

debt finance. Supporting this rationale for convertible debt issuance, several papers

document that firms with greater propensity to shift risk onto bondholders are more likely

to issue convertibles (e.g., Mikkelson, 1981; Lewis et al., 1998, 1999; Krishnaswami and

Yamar, 2004; Gomez and Phillips, 2005). Mayers (1998) also shows how convertibles can

solve sequential-financing problems when the profitability of future investment options is

uncertain. His evidence suggests that convertible bonds control the overinvestment 2 While the bond covenants attached to debt issues might solve some incentive problems, they can be costly to write and enforce, and they can limit a firm’s flexibility to respond to unexpected contingencies. Smith and Warner (1979) find that extensive direct restrictions on investment policy are not common in practice, and a related study by McDaniel (1986) documents almost no restrictions on the ability of firms to increase their risk. Thus, the protection offered by these covenants cannot totally eliminate the agency costs of debt. 3 Ortiz-Molina (2006) and Strock Bagnani et al. (2000) provide evidence relating managerial incentive structures to the agency costs of debt finance.

6

incentives that can arise if financing is provided prior to an investment option’s maturity.

In addition, the data shows that the debt ratios of firms with convertible debt are similar to

those of firms with straight debt only (see Table 2), and Mayers (1998) finds that financial

leverage remains unchanged following conversion because firms issue new debt. As a

result, firms with convertibles in their capital structures differ from firms with straight debt

in that they use security design to mitigate the agency costs of debt. John and John (1993)

show that when convertible debt mitigates the agency costs of debt, compensation

contracts can be designed to better alleviate agency costs of equity by closely aligning

managerial and shareholder interest. Thus, the second and distinct implication of the

agency cost of debt hypothesis is that firms with convertible debt will set higher pay-

performance sensitivities.

Stein (1992) provides an additional reason for the use of convertible bonds that

does not rely on their ability to control shareholder risk-shifting incentives. He argues that,

when informational asymmetries between firms and outside investors are severe,

convertible debt issues can provide “backdoor” equity financing in a way that mitigates the

adverse selection costs of direct equity offerings. However, his model assumes no agency

problems between shareholders and managers or between shareholders and bondholders.

Thus, his analysis provides no prediction relating convertible debt and managerial pay-

performance sensitivities.

To summarize, the implications taken to the data are as follows:

Independence hypothesis: if capital structure does not matter in setting optimal incentives for managers, then capital structure variables should not be related to CEO pay-performance sensitivity.

Agency cost of equity hypothesis: if higher debt mitigates the severity of agency conflicts between the firm’s manager and its shareholders, then CEO pay-performance sensitivity should be decreasing in leverage.

Agency cost of debt hypothesis: if compensation is designed not only to mitigate agency conflicts between managers and shareholders, but also between shareholders and bondholders, then CEO pay-performance sensitivity should be: a) decreasing in leverage due to straight debt, and b) higher in firms with convertible debt.

The discussion above suggests that it is important to explore the role of convertible

debt in the provision of optimal incentives to CEOs and to address the potential

7

endogeneity problems in the analysis. Tests of these hypotheses based on the relation

between pay-performance sensitivity and total financial leverage, but ignoring the

distinction between the two types of debt, would be subject to problems. First, because of

the opposite effects of convertible and straight debt, such tests can be biased against

finding any significant association. Second, a negative relation between pay-performance

sensitivity and total financial leverage can be attributed to either one of the agency

hypotheses. In contrast, tests of the prediction regarding convertible debt provide unique

evidence on the merit of the agency cost of debt story. In addition, both hypotheses point

to the simultaneity of capital structure and compensation decisions. Ignoring this

endogeneity may bias the results and makes causality hard to establish.

3. The data and empirical approach

3.1 Sample

I combine executive compensation data from Standard and Poor’s ExecuComp

with accounting variables from Compustat and stock returns from the Center for Research

in Security Prices (CRSP). I exclude companies in the financial sector, firms without

enough historical data (5 years) to calculate reliable measures of stock price variance in

CRSP, and those with missing data on key accounting variables. I further restrict attention

to CEOs in firms with long-term debt outstanding in at least one year during the sample

period. The final sample consists of 1,652 CEOs in the largest publicly traded U.S.

companies during 1993-1999, with a total of 7,499 CEO-year observations.

3.2 Compensation measures

Table 1 presents summary statistics of the compensation measures, expressed in

thousand dollars of December 1999. The first row shows “Flow Compensation”, i.e., the

amount paid directly to managers, which includes salary, annual bonus, other annual

compensation (such as perquisites and tax reimbursements), long term incentive plans, the

value of restricted stock granted, the Black-Scholes value of new stock options granted and

all other total (such as severance payments). Flow compensation for CEOs averages $2.7

million per year, while the median value is $1.6 million.

8

Insert Table 1 here

It is well known that flow compensation is not the major source of incentives

provided to executives. ExecuComp also contains data on the executives’ holdings of stock

in their own companies and existing options on their companies’ stock. The third row adds

the change in the value of CEOs’ equity holdings to flow compensation. This

compensation measure is denoted “Change in firm-specific wealth, excluding options”.

Adding the change in the value of stocks increases median compensation to almost $2.0

million. Finally, the last row of the table adds the change in the Black-Scholes value of

CEOs’ options held in the company. This all-inclusive compensation measure, denoted

“Change in firm-specific wealth”, is the main dependent variable used in the tests. It

averages $8.0 million and the median value is almost $2.1 million, ranging from a loss of

$122.8 million to a gain of $596.0 million.

3.3 Capital structure variables

Agency problems associated with debt largely relate to how the firm has been

financed in the past, and thus on the relative claims on firm value held by equity and debt.

Thus, the leverage measure I use is market leverage, defined as the book value of debt

divided by the sum of the market value of equity and the book value of debt. Rajan and

Zingales (1995) consider both book leverage and market leverage measures of capital

structure and find that they give similar results in their cross-sectional analysis. For

robustness, I also report results using book leverage, defined as the book value of debt

divided by the book value of assets.

This paper uses long-term debt (debt with one year or more to maturity) to

construct leverage measures, and its decomposition into convertible and straight debt. The

choice of long-term debt reflects the view that risk-shifting incentives regarding

investment policy are more relevant for long-term debt rather than short-term debt (Parrino

and Weisbach, 1999). For robustness, I also conducted the analysis using total debt and all

the qualitative results in the paper remain valid.

Table 2 reports summary statistics for the leverage measures corresponding to

1999, the last year in the sample. The first two rows in the table show that the firms in the

sample have median market leverage of 0.22 and median book leverage of 0.24. The table

9

also reports statistics for levered firms according to whether they had convertible debt or

not (96% of the firms had positive leverage in 1999).

Insert Table 2 here

Almost 15% of the levered firms had convertible debt. Levered firms with

convertible debt have a slightly higher median (and much higher mean) leverage than

levered firms with only straight debt. The share of convertible debt over total long-term

debt for this group of firms is extremely high (40% at the median). These observations

indicate that for some firms convertible debt might play an important role in mitigating the

agency cost of debt.

3.4 Other variables

The performance measure used in this study is the dollar return to shareholders,

computed as the annual real return (which is the nominal return including the monthly

reinvestment of dividends after subtracting the growth in the CPI) times the market value

of the firm at the end of the previous period. Monthly returns and equity values for the

previous 60 months are used to compute the variance of dollar returns to shareholders.

Firm size is the natural logarithm of market capitalization, and the market-to-book ratio is

market value of equity plus book value of debt divided by total assets.

3.5 Empirical approach

As in Jensen and Murphy (1990a), I estimate CEO pay-performance sensitivity by

the empirical relation between changes in a CEO’s firm-specific wealth and changes in

shareholder wealth. My empirical model is similar to that in Aggarwal and Samwick

(1999) and further allows pay-performance sensitivity to depend on capital structure and

control variables. The general form of the model is as follows:

(1) +∗+∗∗+∗+∗∗+∗+= jtjtjtjtjtjtjtjtjt ControlControlRCSCSRRW εββββββ 543210

where j denotes the firm to which the CEO belongs and t denotes year. W is the change in

CEO firm-specific wealth in $ thousands, R is shareholder return in $ million, CS is a

generic capital structure variable to be specified later, and Control is a vector of control

variables. Pay-performance sensitivity is then given by the following expression:

(2) 421 ControlCSRW

∗+∗+=∂∂ βββ

10

and is measured in dollars per thousand-dollar increase in the return to shareholders. Thus,

β2 captures the effect of capital structure variables on pay-performance sensitivity.

Note that capital structure and compensation decisions are determined

simultaneously. Firms can minimize the agency costs created by managerial discretion and

misaligned incentives by optimizing jointly over capital structure and compensation

decisions. For example, both debt and ownership could be employed as alternative means

to limit free cash-flow problems. Alternatively, managerial preference for debt might be

determined by ownership, and managers might have discretion about capital structure

choices because of imperfections in corporate governance, or because of informational

advantages over shareholders. Thus, estimates of β2 in models of the form given by (1)

may be inconsistent unless all the capital structure terms are properly instrumented.

As it is typical in the executive compensation literature (and evident in Table1), the

right skewness of the data and the presence of large outliers require a robust estimation

method. Following previous research, I use median regression (also known as least

absolute deviation regression) throughout the analysis. To address the simultaneity of

capital structure and compensation decisions, I need to instrument some of the right-hand

side variables. Thus, I use the Two Stage Least Absolute Deviation estimator (2SLAD)

proposed by Amemiya (1982), which is the analog to two-stage least squares (2SLS) in a

median regression framework. The 2SLAD estimation used in this paper amounts to an

OLS first stage and median regression in the second stage. The statistical significance of

the coefficients is calculated using bootstrapped standard errors based on 20 replications.

4. Analysis of the relation between CEO pay and capital structure

4.1 Pay-performance sensitivity and financial leverage

In this sub-section I address the question whether financial leverage matters in

setting CEO incentives. Both the agency cost of equity and the agency cost of debt

hypotheses predict a negative relation between pay-performance sensitivity and financial

leverage, while the null hypothesis is that they are not related. Thus, my empirical model

takes the following form:

11

)( +∗+∗+

∗+∗∗ + ∗+∗∗ +

∗+∗∗+∗+∗∗+∗+=

∑∑==

3

)()()()(

)()(

99

93

99

1

2121

212

22

1

jtt

ttj

jj

jtjtjtjtjtjt

jtjtjtjtjtjtjtjt

YearSIC

MTBRFMTBRFRSizeFSizeFR

LLRFFRRW

εµθ

δδωω

γγσλσλβα

where j denotes the firm to which the CEO belongs and t denotes year. W is the change in

CEO firm-specific wealth, R is dollar return to shareholders, F(σ2) is the empirical CDF of

the variance of dollar returns, L is financial leverage (market or book value), F(Size) is the

empirical CDF of the firm’s market capitalization, and F(MTBR) is the empirical CDF of

the firm’ market-to-book ratio.4 The last two terms contain two-digit SIC industry and year

dummies, respectively. The terms including F(σ2) are included because principal-agent

models predict that pay-performance sensitivity is decreasing in the risk of equity.

Aggarwal and Samwick (1999) show that estimates of the pay-performance sensitivity that

do not control for the risk of equity are biased towards zero.5 A negative relation between

pay-performance sensitivity and firm size has been documented in previous studies (e.g.,

Gibbons and Murphy, 1992a). In addition, equity and options are typically used more

intensively in the compensation of executives in growth firms (e.g., Smith and Watts,

1992). Thus, F(Size) and F(MTBR) are included as additional controls.

Pay-performance sensitivity is then given by the following expression:

(4) )()()( 1112

1 MTBRFSizeFLFRW

∗ +∗+∗+∗+=∂∂ δωγσλβ

Table 3 shows the median regression (MR) and 2SLAD parameter estimates of

equation (3). The key parameter of interest is γ1, which captures the dependence of pay-

performance sensitivity on financial leverage. The proposed instruments for the financial

leverage terms are industry-level capital intensity, the natural logarithm of the firm’s

assets, and additional variables constructed using the predetermined variables of the model.

The details of the instrumentation are discussed in the Appendix.

4 Using empirical CDFs to normalize the continuous control variables to the unit interval diminishes the importance of extreme outliers and makes the economic interpretation of the coefficients easier. Because L already ranges between zero and one, it is not severely affected by outliers, and it is desirable to preserve its original variation for the instrumentation in the 2SLAD procedure, I keep L in its original form. 5 To be consistent with standard agency theory, risk is also measured in dollars, which renders it roughly invariant to changes in firm leverage. If debt is assumed to be riskless, the total dollar risk of firm equity will remain constant even as the percentage risk of the firm’s equity changes with firm leverage.

12

Insert Table 3 here

As a benchmark, column (1) reports the MR results for the specification in

Aggarwal and Samwick (1999), which includes the terms containing F(σ2) but excludes

those containing leverage, size, and the market-to-book ratio. Consistent with their

findings, pay-performance sensitivity is decreasing in the variance of performance as

predicted by principal-agent models. Column (2), which includes the market leverage

terms but does not account for their potential endogeneity, shows a negative and

statistically significant effect of financial leverage on pay-performance sensitivity (γ1<0).

The 2SLAD estimate of γ1 reported in column (3) is again negative and statistically

significant, but much larger in magnitude. Thus, neglecting the endogeneity of the leverage

terms biases the results towards finding no effect.

To the extent that leverage is positively correlated with size and negatively

correlated with growth opportunities, the negative estimates of γ1 could be capturing the

effect of either of these variables on pay-performance sensitivity. Column (4) allows pay-

performance sensitivity to depend on firm size and the market-to-book ratio. The estimates

of γ1 are again negative and statistically significant but somewhat smaller than those in the

previous column. The effect of firm size on pay-performance sensitivity is statistically

significant and negative as expected, while the effect of the market-to-book ratio is not

statistically significant. For robustness, the last two columns of the table report the 2SLAD

results using book leverage. The results are statistically significant and similar to those

obtained using market leverage.

The finding that pay-performance sensitivity decreases in leverage is inconsistent

with the null hypothesis that capital structure has no effect on the provision of managerial

incentives. However, the finding is consistent with both the agency cost of equity

hypothesis that debt mitigates shareholder-manager conflicts of interest, and with the

agency cost of debt hypothesis that shareholders also use the CEO’s contract to mitigate

shareholder-bondholder conflicts and not only to address the standard manager-owner

agency problem. A more powerful test of this second hypothesis involves distinguishing

convertible and straight debt, which is the focus of the next sub-section.

13

4.2 Can stockholder-bondholder conflicts explain the lack of incentives?

This section examines whether convertible debt and straight debt have different

effects on pay-performance sensitivity. While the agency cost of equity hypothesis predicts

a negative association between managerial incentives and leverage, the agency cost of debt

hypothesis implies that pay-performance sensitivity should be decreasing in leverage due

to straight-debt, but higher in firms with convertible debt. Thus, by separating straight

from convertible debt, we can provide a stronger test of the agency cost of debt hypothesis

and distinguish it from the agency cost of equity hypothesis.6

To examine how the pay-performance relation depends on financial leverage and

the use of convertible debt, I estimate the following empirical model:

)( +∗+∗+∗+∗∗ +

∗+∗∗ +∗+∗∗+

∗+∗∗+∗+∗∗+∗+=

∑∑==

5 )()(

)()(

)()(

99

93

99

121

2121

212

22

1

jtt

ttj

jjjtjtjt

jtjtjtCjt

Cjtjt

Sjt

Sjtjtjtjtjtjtjt

YearSICMTBRFMTBRFR

SizeFSizeFRLLR

LLRFFRRW

εµθδδ

ωωππ

γγσλσλβα

where LS, leverage due to straight debt, is defined as the book value of straight debt

divided by the market or book value of assets, and LC is a dummy variable equal to one if

the firm has convertible debt outstanding, and zero otherwise. Pay-performance sensitivity

is now calculated as:

(6) )()()( 11112

1 MTBRFSizeFLLFRW CS ∗+∗ +∗+∗+∗+=

∂∂ δωπγσλβ

where γ1<0 and π1>0 would provide support for the agency costs of debt hypothesis.

As in the previous section, the 2SLAD estimation of equation (5) requires

addressing the endogeneity of the four terms including LS and LC. The instruments are

industry-level capital intensity, industry-level profitability, the natural logarithm of the

firm’s assets, and additional variables constructed using the predetermined variables of the

model and the main instruments. Other details of the instrumentation are discussed in the

Appendix. Table 4 presents the results for both median regression (MR) and 2SLAD. 6 I use the existence and amount of convertible debt outstanding to proxy for the incentive effects of convertibles in a firm’s capital structure. In practice, each specific convertible bond issue outstanding has different features, such as issue date, maturity, conversion features, current moneyness, etc. However, because firms with convertible debt clearly have different incentive effects than firms without any convertible debt, and because larger amounts are more likely to mitigate stockholder-bondholder conflicts than smaller amounts, my proxies capture the main effects that are the focus of this study.

14

Column (1) reports the median regression results using market leverage, where the

endogeneity is neglected. Columns (2)-(5) report the results accounting for endogeneity,

controlling for size and growth opportunities, and using both market and book leverage.

Insert Table 4 here

As in Table 3, where both types of debt were included in the leverage measure, the

estimates of γ1 are negative and statistically significant. However, the magnitude of the

estimates of γ1 is generally larger across most specifications. This suggests that, because

the opposite effects of convertible and straight debt on pay-performance sensitivity tend to

cancel each other, tests that do not separate these different types of debt are biased towards

finding a smaller effect. In other words, because convertible debt tends to mitigate

stockholder-bondholder conflicts, leverage measures that exclude convertible debt are a

more precise proxy for the severity of stockholder-bondholder conflicts that could be

mitigated through the use of managerial incentive contracts.

The new result in Table 4 is the effect of convertible debt on pay-performance

sensitivity. The estimate of π1 is positive and statistically significant across all

specifications. The estimates of π1 in the 2SLAD regressions are larger in magnitude than

those in the median regressions reported in column (1), which ignores endogeneity. Again,

this suggests that neglecting the endogeneity of the leverage terms biases the results.

Column (3) adds firm size and the market-to-book ratio as additional controls. This may be

important because size and growth opportunities may be correlated with both leverage due

to straight debt and managerial incentives. In addition, small or growth firms may be more

likely to issue convertible debt and also to use more equity-based compensation to preserve

cash for investments. However, the results are unaffected by the inclusion of the market-to-

book ratio and firm size. The last two columns show similar effects when book leverage is

used instead of market leverage.

To summarize, by separating straight and convertible debt, which have different

theoretical implications for CEO incentives, the tests in this sub-section can distinguish

between the agency cost of equity and the agency cost of debt hypotheses. The negative

effect of straight debt and the positive effect of convertible debt on pay-performance

sensitivity provide strong support for the agency cost of debt hypothesis. Ignoring the

15

distinction between the two debt types or failing to address the endogeneity problem both

bias the results towards finding no effect of capital structure on executive incentives.

The effect of capital structure on CEO incentives is also economically important.

The estimates in column (2) imply that, everything else equal, a firm with no debt would

have CEO pay-performance sensitivity of $12.7 per thousand-dollar increase in

shareholder return. Without convertible debt, sensitivity falls to $10.0 at a firm with

median leverage (0.21), to $7.8 at a firm with 75th percentile leverage (0.39), and to $5.0 at

a firm with 95th percentile leverage (0.61). The results also show that, everything else

constant, CEOs in firms with convertible debt have pay-performance sensitivities that are

on average $5.9 higher than for CEOs in firms without convertible debt.7

5. A closer look at the effect of capital structure on pay-performance sensitivity

If more levered firms set lower CEO pay-performance sensitivity to mitigate

shareholder-bondholder conflicts of interest regarding risk-taking, stock options may play

an important role. Due to their convexity, executive stock options typically provide higher

risk-taking incentives than stock (e.g., Guay, 1999), and thus are likely to cause higher

agency costs of debt.8 Supporting this view, Ortiz-Molina (2006) finds that prospective

bondholders anticipate higher risk-shifting incentives from managerial stock options than

from equity ownership. Thus, the agency cost of debt hypothesis suggests that option-

based compensation should be relatively less attractive for more levered firms. However,

as convertibles mitigate risk-taking incentives, firms with convertible debt may have more

freedom in using stock options to pay their CEOs.

To explore these issues, this section investigates how more levered firms induce

lower pay-performance sensitivities. I first decompose pay-performance sensitivity into its

stock and stock option components and examine how they change with capital structure. I

then focus on annual CEO compensation and examine how capital structure affects pay-

performance sensitivity as well as stock and stock option policy.

7 While these estimates are suggestive of the magnitude of the effects, they should, however, be taken with caution as they assume that we can change capital structure while keeping everything else constant. 8 Empirical studies find that stock options encourage risk-taking (see Datta et al., 2001; Coles et al., 2006; Rajgopal and Shevlin, 2000). In contrast, Lambert et al. (1991) show that undiversified, risk-averse executives holding options that are expected to finish far in the money can become more risk averse.

16

5.1 Analysis of stock and stock option components of pay-performance sensitivity

Table 5 attempts to disentangle the effects of capital structure on pay-performance

sensitivity arising from the two main components of the change in CEO firm-specific

wealth: the change in the value of equity holdings and the change in the value of stock

option holdings (flow compensation is analyzed in the next sub-section). Panel A, which

uses market leverage, reports the 2SLAD estimates of equation (5) for the change in the

value of stock and stock option holdings separately. As a benchmark, column (1) repeats

the estimates for the total change in CEO firm-specific wealth.

Insert Table 5 here

For both the change in stock holdings and the change in stock option holdings, the

estimates of γ1 are negative and the estimates of π1 are positive, and both are statistically

significant. Thus, the qualitative results mirror those in column (1), where the dependent

variable is the total change in CEO firm-specific wealth.

Panel B reports the estimates of CEO pay-performance sensitivity for different

financial structures assuming F(σ2)=.5 and LC=0. In an all-equity firm, the sensitivity

coming from stock option holdings is about 1.6 times the sensitivity coming from stock

holdings ($6.29 vs. $3.84). At the 95th percentile leverage, the sensitivity coming from

options is about one-third of the sensitivity from stock holdings ($0.77 vs. $2.08). Thus,

the pay-performance sensitivity related to CEO wealth in stock options falls more rapidly

than that related to wealth in stock, and the importance of stock options in providing

incentives decreases relative to that of stocks.9 In addition, the effect of convertible debt on

pay-performance sensitivity is much stronger for the change in the value of stock option

holdings than for the change in the value of stock holdings ($4.21 vs. $1.73).

Overall, supporting the agency cost of debt hypothesis, these results are consistent

with the intuition that more severe stockholder-bondholder conflicts in highly levered

firms make option-based compensation relatively less attractive, unless convertible debt

mitigates these conflicts.10 The following sub-section further explores these issues.

9 I also regress the share of option holdings in the total value of CEOs’ portfolios of stock and stock options on leverage, the market-to-book ratio, the natural logarithm of assets, sales per employee, percentage return to shareholders, variance of returns, CEO tenure, CEO annual pay, industry and year fixed-effects. I find that the share of options in managerial portfolios decreases in leverage. 10 Higher leverage increases the convexity of CEOs’ payoff from equity holdings, providing incentives that are closer to those given by options. This may partially explain the diminished importance of stock options.

17

5.2 Analysis of flow compensation

As in most previous research, my analysis assumes that the board of directors has

full discretion in setting CEO pay-performance sensitivity. In particular, it assumes that

CEO ownership is a choice variable controlled by the board. However, the board may not

have direct control over a CEO’s vested stock and stock option holdings, which can reflect

personal portfolio choices rather than incentive alignment decisions by the board (Ofek and

Yermack, 2000). Thus, I now examine the effect of capital structure on CEO flow

compensation, which only comprises direct annual payments to CEOs and is directly

controlled by a firm’s board of directors. In addition, looking into the components of flow

compensation (restricted stock and stock option grants in particular) helps to disentangle

the effects of capital structure on the provision of risk-taking incentives to CEOs.

Table 6 estimates equation (5) using flow compensation as the dependent variable.

Flow compensation includes salary, bonus, other annual compensation (short term), long-

term incentive plans (LTIP), restricted stock grants, option grants, and all other

compensation (long term). As a benchmark, column (1) reports the median regression

results omitting the leverage terms. Column (2) adds the market leverage terms, but does

not account for endogeneity, while column (3) reports the 2SLAD estimates. For

robustness, column (4) reports the 2SLAD results using book leverage.

Insert Table 6 here

The estimates of γ1 in columns (2)-(4) are negative and statistically significant,

consistent with pay-performance sensitivity decreasing in leverage. However, the estimates

of π1 are not statistically significant. The estimates imply that the pay-performance

sensitivity of CEO flow compensation goes from $0.80 in an all-equity firm to $0.38 in a

firm with 95th percentile leverage. These results are consistent with the analysis in section

4, where the value change of CEO wealth in stock and stock options was included in

calculating pay-performance sensitivities.

Table 7, which reports the composition of flow compensation for different capital

structures, provides additional insights about how firms set managerial incentives.

Insert Table 7 here

In firms with no convertible debt, the share of CEO compensation in the form of

salary and bonus increases, while the share of equity-based pay decreases with leverage.

18

While the median CEO does not receive restricted stock in a year, the mean CEO tends to

receive a somewhat larger proportion of her compensation in stock as leverage increases.

However, the median value of option grants falls substantially from 28.7% to 10.9% of

annual compensation as leverage increases from the first to the fourth quartile. This is

consistent with more levered firms setting lower risk-taking incentives for their CEOs in

order to mitigate agency costs of debt. In addition, CEOs in firms with convertible debt

receive a smaller share of their annual pay in the form of salary and bonus, and a larger

share in the form of equity-based compensation, especially stock options (31.0% vs. 21.5%

at the median). This suggests that convertible debt mitigates the agency cost of debt

finance and allows firms to provide more risk-taking incentives to their CEOs.11

It remains to examine how capital structure affects a firm’s decision to grant new

stock and stock options to its CEO. Table 8 reports the marginal effects of Probit models

which estimate the probability that a CEO is granted stock options and restricted stock,

respectively. For these models, all independent variables are lagged one year, and include

the two leverage terms (LS and the LC dummy), a vector of firm and executive control

variables (the market-to-book ratio, firm size, sales per employee, percentage annual return

to shareholders, variance of percentage returns, CEO tenure, annual compensation,

ownership of stock, and ownership of stock options), industry and year effects. An

advantage of estimating the probability of an option grant is that the value of executive

stock options is not required. Hence, the results are independent of any option valuation

concerns.

Insert Table 8 here

The negative coefficients on LS in columns (1) and (3) indicate that CEOs in more

levered firms are less likely to receive stock option grants. In addition, firms with

convertible debt are more likely to grant new options to their CEOs. I also find that stock

grants to CEOs are positively related to leverage, but the effect of convertible debt is not

statistically significant. While total pay-performance sensitivity from annual compensation

decreases with leverage (see Table 6), the opposite effects of straight debt on new share

and option grants reported in Table 8 are consistent with shareholders substituting stock for

11 The patterns documented in the table also emerge if I regress the share of each component of annual compensation on leverage, the convertible debt dummy, and a vector of control variables that previous research shows to affect compensation structure.

19

stock options to reduce risk-taking incentives by CEOs. Recall, however, that the fraction

of total compensation corresponding to stock options is substantially larger than that

corresponding to restricted shares (see Table 7). Thus, the net effect of increases in the

likelihood of stock grants and decreases in the likelihood of stock option grants is

decreasing pay-performance sensitivity. Overall, the evidence in Table 8 is consistent with

shareholders using stock and stock option policy to set pay-performance sensitivities and

incentives to take risk as suggested by the agency costs of debt hypothesis.

To summarize, the analysis of annual compensation to CEOs (which is directly

controlled by the board of directors) is consistent with my previous findings using the total

change in CEO firm-specific wealth to compute pay-performance sensitivity. In addition,

stock option policy is the component of the pay-performance relation that is most sensitive

to cross-sectional differences in capital structure. This finding is consistent with the agency

costs of debt hypothesis, which suggests that shareholders set incentive structures for their

CEOs taking into account that managerial incentives to take risk generate agency costs of

debt finance.

6. Additional robustness checks

Since ExecuComp only reports the value of existing options that are currently in

the money, my analysis uses the change in the value of in-the-money options to

approximate the value change of total option holdings. Aggarwal and Samwick (1999)

discuss the possible bias from this reporting convention and conclude that it is not severe.

In addition, Hall and Murphy (2002) argue that the Black-Scholes formula might not be

appropriate to value non-tradable options held by a risk-averse executive. For robustness, I

repeat the analysis using the change in firm-specific wealth excluding options as the

dependent variable. The qualitative results are similar to those reported.

Given the right skewness of the data, and the presence of large outliers, this paper

uses robust estimation methods: median regression and Amemiya’s (1982) Two-Stage

Least Absolute Deviations (2SLAD) estimator. I also conducted the analysis using

standard OLS and 2SLS, and all the results remain valid, although the coefficients are in

general larger (because of the right skewness) and less precise (because of the outliers).

The analysis uses long-term debt and its decomposition into convertible and

straight debt. The choice of long-term debt reflects the view that risk-shifting incentives

20

regarding investment policy are more relevant for long-term debt rather than short-term

debt. Using total debt, which includes debt in current liabilities, does not affect the

qualitative results of the paper.

Given that only 15% of the firms in the sample have convertible debt, the

estimation of equation (5) specifies LC as an indicator variable for whether the firms have

convertible debt or not. For robustness, I estimated the following alternative model:

)( +∗+∗+∗+∗∗ +

∗+∗∗ +∗+∗∗+

∗+∗∗+∗+∗∗+∗+=

∑∑==

7 )()(

)()(

)()(

99

93

99

121

2121

212

22

1

jtt

ttj

jjjtjtjt

jtjtjtjtjtjt

jtjtjtjtjtjtjtjt

YearSICMTBRFMTBRFR

SizeFSizeFRCDSHARECDSHARER

LLRFFRRW

εµθδδ

ωωππ

γγσλσλβα

where L is total financial leverage and CDSHARE is the fraction of total debt that is

convertible. In this specification, γ1 captures the effect of leverage on pay-performance

sensitivity, and π1 gives the effect due to the composition of debt while keeping leverage

constant. The estimates of γ1 and π1 were -10.433 and 7.465, respectively, and statistically

significant. Thus, the results in Table 4 are robust to alternative specifications.

While cross-sectional regressions are more appropriate to test my cross-sectional

hypotheses, it could be argued that the analysis does not control for unobserved executive

or firm heterogeneity. In addition, omitted risk factors that are correlated with leverage

could bias the results. To address this issue, I repeat the analysis using executive-firm

fixed-effects. All my results are similar in magnitude and significance to those reported.

Finally, one question that arises when estimating models with interaction terms is

whether this introduces multicollinearity problems. Inconsistent with the common

symptoms of multicollinearity, my estimates are stable and statistically significant across

specifications, suggesting that multicollinearity is not a problem in my estimation. I also

checked if the inclusion or exclusion of interaction terms affects the results. Starting with

the basic empirical model with no leverage terms, I then sequentially added all other

interaction terms containing leverage variables, size, and market-to-book. The magnitudes,

significance and signs of the estimates are similar to those reported.

7. Summary and conclusions

This paper provides an in-depth analysis of how firms’ capital structures affect

CEO compensation practices. Against the null hypothesis of no relation between capital

21

structure and compensation, I test two main (non-exclusive) hypotheses. These are that

debt affects the provision of optimal incentives to managers because it mitigates

shareholder-manager conflicts (the agency cost of equity hypothesis) and that optimal

incentives depend not only on the agency relation between managers and owners, but also

on the agency conflict between owners and lenders (the agency cost of debt hypothesis).

I document an economically important effect of capital structure on CEOs’ high-

powered incentives. Pay-performance sensitivity decreases in straight debt, but is higher

for firms with convertible debt. As leverage increases, the sensitivity to firm performance

of managerial wealth in stock options falls more rapidly than that of wealth in stocks. In

addition, both the fraction of annual CEO pay in the form of stock options and the

probability of receiving new option grants decrease in leverage, but they increase in the

amount of convertible debt. Thus, stock option policy is the component of the pay-

performance relation that is most sensitive to differences in capital structure.

The findings provide strong support for the agency cost of debt hypothesis, which

predicts that CEO pay-performance sensitivity decreases in financial leverage but it is

higher in firms with convertible debt. In addition, the evidence is consistent with the

intuition that, due to their convexity, stock options are less attractive when stockholder-

bondholder conflicts regarding risk choices can lead to high agency costs of debt. While

the agency cost of equity hypothesis can also explain the negative effect of leverage on

managerial incentives, this hypothesis alone cannot explain the convertible debt results or

the especial role of stock options. Overall, this study suggests that capital structure and

executive compensation practices are related in an economically important way that cannot

be neglected.

22

Appendix: More detail on the 2SLAD instrumentation of equations (3) and (5)

The endogenous variables in equation (3) are R*L and L and those in (5) are R*LS,

LS, R*LC and LC. The vectors of instruments (Zi) include industry-level variables, the

logarithm of firm’s assets (LNASSETS), and additional variables constructed using the

predetermined variables of the model. The use of industry-level variables guarantees the

exogeneity of the instruments. The two industry-variables, which are calculated at the 3-

digit SIC codes, are asset tangibility defined as fixed assets divided by total assets (FIXED)

and profitability defined as operating income divided by sales (PROF). The (unknown)

reduced-form for the interaction terms is likely to be non-linear, which I approximate with

squared terms and interactions between the independent variables and the industry-level

instruments. The instruments for equations (3) and (5) are given below:

Z3 = {R2 , R2*F(σ2) , FIXED , FIXED2 , R*FIXED , R2

*FIXED , LNASSETS},

Z5 = {R2 , R2*F(σ2) , FIXED , FIXED2 , R*FIXED , R2

*FIXED , PROF, PROF2 ,

R*PROF , R2*PROF , FIXED*PROF , LNASSETS}

The tradeoff theory predicts a positive relation between leverage (both total and due

to straight debt) and inverse proxies for expected bankruptcy costs such as fixed assets and

firm size. The pecking order theory predicts a negative relation between leverage and

profitability. Also, Brennan and Kraus (1987) and others suggest that firms facing high

financial distress and adverse selection costs are more likely to issue convertibles. This

predicts a negative effect of firm size and fixed assets on the use of convertible debt.

Further, the pecking order theory predicts that more profitable firms rely first on debt and

then on equity-like securities if they approach external capital markets. Thus, more

profitable firms may be less likely to issue convertible bonds.

For both equations, the first-stage regressions show that asset tangibility and firm

size increase, while profitability decreases straight debt and total leverage. In addition,

profitability and firm size increase the likelihood of using convertible debt in my sample.

An F-test at 5% significance rejects the null that the coefficients of variables contained in Z

are jointly zero in all cases. Furthermore, the Hausman test rejects the null that the

difference between the coefficients from 2SLAD and median regression is not systematic.

The first-stage regression results are available from the author.

23

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26

Table 1 Measures of CEO compensation, 1993-1999

The sample consists of 1,652 CEOs in firms that had long-term debt outstanding in at least one of the years in the period 1993-1999, with a total of 7,499 CEO-year observations. All dollar amounts are in thousands of December 1999 dollars. Option grants are valued according to the Black-Scholes formula. Flow Compensation = salary + bonus + other annual compensation + long-term incentive plans + restricted stock grants + option grants + all other compensation. The Change in the value of the stocks is the annual dollar change in the value of the CEO’s equity holdings. The Change in the value of options is the dollar change in the Black-Scholes value of the CEO’s “in the money” stock-option holdings. The median change in the value of options is small ($5.5 thousands) because it was recorded as zero for CEOs with no stock options. This reduces the magnitude of the change in value, as only 89% of the observations in the dataset contain positive stock option holdings by CEOs. For those CEOs that held positive amounts of options, the median change in value was $104.8 thousands. The change in firm-specific wealth excluding options is the sum of flow compensation and the change in the value of stocks. The change in firm-specific wealth is the sum of flow compensation, the change in the value of stocks, and the change in the value of options.

# obs. Mean Median Min Max

Flow Compensation 7,499 2,669.0 1,553.2 89.7 33,342.8 Change in value of stocks 7,499 3,582.1 169.7 -120,285.9 519,502.3 Change in firm-specific wealth, excluding options 7,499 6,251.1 1,997.9 -116,729.5 522,260.1 Change in value of options 7,499 1,754.0 5.5 -125,778.2 349,176.1 Change in firm-specific wealth 7,499 8,005.1 2,091.9 -122,869.7 596,504.5

27

Table 2 Summary statistics of leverage measures, 1999

Market leverage is defined as the book value of long-term debt / (book value of long-term debt + market value of equity). Book leverage is the book value of long-term debt / assets. The numerator in leverage due to straight debt is the book value of non-convertible long-term debt, while the numerator in leverage due to convertible debt is the book value of convertible long-term debt. Levered firms are 96% of the firms in the sample for 1999. Of the levered firms, only 14.9% have convertible debt in 1999. # obs. Mean Median Min Max All firms

Market Leverage 905 0.25 0.22 0.0000 0.95 Book Leverage 905 0.24 0.24 0.0000 1.20 Levered firms with straight debt only

Market Leverage 739 0.26 0.23 0.0002 0.95 Book Leverage 739 0.24 0.24 0.0001 1.18 Levered firms with some convertible debt

Market leverage 129 0.30 0.24 0.0002 0.76 Market leverage due to straight debt 129 0.18 0.13 0.0000 0.72 Market leverage due to convertible debt 129 0.11 0.08 0.0001 0.70 Book leverage 129 0.32 0.30 0.0011 1.20 Book leverage due to straight debt 129 0.17 0.15 0.0000 0.66 Book leverage due to convertible debt 129 0.15 0.11 0.0002 1.20 Convertible debt/Long-term debt 129 0.48 0.40 0.0006 1.00

28

Table 3 Estimates of pay-performance sensitivity as a function of total financial leverage

The table reports median regression (MR) and two-stage least absolute deviation (2SLAD) estimates of the following equation:

,)()(

)()()()( 99

93

99

121

21212

22

1

jtt

ttj

jjjtjtjt

jtjtjtjtjtjtjtjtjtjtjt

YearSICMTBRFMTBRFR

SizeFSizeFRLLRFFRRW

εµθδδ

ωωγγσλσλβα

+∗+∗+∗+∗∗ +

∗+∗∗ +∗+∗∗+∗+∗∗+∗+=

∑∑==

where W is the change in firm-specific wealth, R is the dollar return to shareholders, σ2 is the variance of dollar returns, L is financial leverage, Size is the natural logarithm of market capitalization, and MTBR is the market to book ratio. F() denotes the empirical CDF of the variable. All regressions include 2-digit SIC industry and year fixed-effects (not reported). The t-statistics reported in parenthesis are constructed using bootstrapped standard errors based on 20 replications. ***, **, * means significant at 1%, 5% and 10% respectively.

Market Leverage Book Leverage (1) (2) (3) (4) (5) (6) MR MR 2SLAD 2SLAD 2SLAD 2SLAD

R 20.325 *** 21.425 *** 25.317 *** 23.581 *** 24.102 *** 21.025 *** (25.34) (18.31) (16.50) (7.15) (23.48) (17.07) R*F(σ2) -18.928 *** -19.740 *** -22.660 *** -14.684 *** -20.977 *** -14.782 *** (22.35) (16.40) (18.26) (7.44) (29.68) (6.49) F(σ2) 2,688.719 *** 2,644.594 *** 2,495.568 *** -200.736 2,428.435 *** -346.625 (13.44) (13.07) (8.92) (0.50) (7.32) (0.99) R*L -3.197 *** -11.732 *** -9.060 ** -10.572 *** -5.841 ** (4.64) (3.53) (1.98) (4.58) (2.55) L 73.201 7,069.162 *** 1,182.905 ** 8,237.136 *** 2,304.169 ** (0.24) (5.30) (2.29) (5.86) (2.38) R*F(Size) -6.081 ** -5.378 ** (2.35) (2.26) F(Size) 3,272.868 *** 3,411.022 *** (7.28) (11.25) R*F(MTBR) -0.518 2.089 *** (0.31) (4.43) F(MTBR) 378.973 93.329 (1.20) (0.39) Pseudo R2 0.1791 0.1820 0.1844 0.1889 0.1824 0.1891 # Obs. 7,499 7,499 7,499 7,499 7,499 7,499

29

Table 4 Estimates of pay-performance sensitivity as a function of straight and convertible debt financial leverage

The table reports median regression (MR) and two-stage least absolute deviation (2SLAD) estimates of the following equation:

,

)()()()(

)()(

99

93

99

1

2121

21212

22

1

+∗+∗+

∗+∗∗ + ∗+∗∗ +

∗+∗∗+∗+∗∗+∗+∗∗+∗+=

∑∑==

jtt

ttj

jj

jtjtjtjtjtjt

Cjt

Cjtjt

Sjt

Sjtjtjtjtjtjtjt

YearSIC

MTBRFMTBRFRSizeFSizeFR

LLRLLRFFRRW

εµθ

δδωω

ππγγσλσλβα

where W is the change in firm-specific wealth, R is the dollar return to shareholders, σ2 is the variance of dollar returns, LS is financial leverage due to straight debt, LC equals one is the firm has convertible debt outstanding and zero otherwise, Size is the natural logarithm of market capitalization, and MTBR is the market to book ratio. F() denotes the empirical CDF of the variable. All regressions include 2-digit SIC industry and year fixed-effects (not reported). The t-statistics reported in parenthesis are constructed using bootstrapped standard errors based on 20 replications. ***, **, * means significant at 1%, 5% and 10% respectively.

Market Leverage Book Leverage MR 2SLAD 2SLAD 2SLAD 2SLAD (1) (2) (3) (4) (5)

R 21.349 *** 23.096 *** 19.258 *** 21.890 *** 17.958 *** (16.71) (17.96) (12.24) (20.58) (11.11) R*F(σ2) -19.687 *** -20.837 *** -16.352 *** -18.883 *** -16.636 *** (14.90) (17.40) (6.33) (21.31) (9.83) F(σ2) 2,561.835 *** 2,652.830 *** -174.123 2,311.655 *** -436.003 (13.24) (10.09) (0.36) (8.90) (0.88) R*LS -4.526 *** -12.558 *** -7.998 ** -11.871 *** -6.673 *** (5.86) (5.02) (2.36) (6.94) (4.93) LS 102.999 7,158.271 *** 1,233.164 7,584.844 *** 2,342.794 ** (0.34) (7.72) (1.13) (5.96) (2.07) R*LC 1.293 ** 5.859 *** 5.850 *** 4.340 *** 5.539 *** (1.97) (3.91) (4.57) (2.59) (3.21) LC 266.377 * 4,397.373 *** 783.838 7,560.936 *** 2,213.043 * (1.86) (3.13) (0.50) (4.74) (1.27) R* F(Size) -0.477 -0.146 (0.17) (0.98) F(Size) 3,181.859 *** 3,434.268 *** (5.83) (6.42) R*F(MTBR) -0.738 1.256 ** (0.49) (3.62) F(MTBR) 984.278 ** 796.310 ** (2.31) (2.16) Pseudo R2 0.1850 0.1905 0.1961 0.1896 0.1968# Obs. 7,499 7,499 7,499 7,499 7,499

30

Table 5

Pay-performance sensitivities for different components of CEO firm-specific wealth Panel A reports two-stage least absolute deviation (2SLAD) estimates of the following equation:

,

)()( 99

93

99

1

21212

22

1

+∗+∗+

∗+∗∗+∗+∗∗+∗+∗∗+∗+=

∑∑==

jtt

ttj

jj

Cjt

Cjtjt

Sjt

Sjtjtjtjtjtjtjt

YearSIC

LLRLLRFFRRW

εµθ

ππγγσλσλβα

In column (1) W is the change in firm-specific wealth, in column (2) it is the change in the value of stocks, and in column (3) it is the change in the value of stock options. R is the dollar return to shareholders, F(σ2) is the empirical CDF of the variance of dollar returns, LS is market financial leverage due to straight debt, and LC equals one is the firm has convertible debt outstanding and zero otherwise. All regressions include 2-digit SIC industry and year fixed-effects (not reported). The t-statistics reported in parenthesis are constructed using bootstrapped standard errors based on 20 replications. ***, **, * means significant at 1%, 5% and 10% respectively. Panel B uses the estimates from Panel A to compute pay-performance sensitivity for a firm with median variance of returns (F(σ2) = .5), no convertible debt (LC = 0) and different amounts of debt using market leverage statistics for 1999. The sensitivity figure gives the dollar increase in CEO pay per thousand dollar of increase in the return to shareholders. Panel A: 2SLAD estimates Dependent Variable:

Change in wealth

(1)

Change in the value of stocks

(2)

Change in the value of options

(3)

R 23.096 *** 7.416 *** 11.061 *** (17.96) (6.67) (22.43) R*F(σ2) -20.837 *** -7.154 *** -9.550 *** (17.40) (6.53) (21.49) F(σ2) 2,652.830 *** -79.134 -140.272 (10.09) (0.32) (1.24) R*LS -12.558 *** -2.879 *** -9.047 *** (5.02) (2.77) (10.29) LS 7,158.271 *** 1,090.117 2,398.419 *** (7.72) (0.46) (5.40) R*LC 5.859 *** 1.732 *** 4.211 *** (3.91) (3.06) (5.94) LC 4,397.373 *** 242.236 -1,399.429 *** (3.13) (0.83) (2.71) Panel B: Pay-performance sensitivities

No Debt 12.68 3.84 6.29 Median Leverage 10.04 3.23 4.39 75th Pctile. Leverage 7.78 2.72 2.76 95th Pctile. Leverage 5.02 2.08 0.77 % Change No Debt vs. 95th Pctile. -60.43 -45.75

-87.79

# Obs. 7,499 7,499 7,499

31

Table 6 Pay-performance sensitivity from flow compensation

The table reports median regression (MR) and two-stage least absolute deviation (2SLAD) estimates of the following equation:

,

)()( 99

93

99

1

21212

22

1

+∗+∗+

∗+∗∗+∗+∗∗+∗+∗∗+∗+=

∑∑==

jtt

ttj

jj

Cjt

Cjtjt

Sjt

Sjtjtjtjtjtjtjt

YearSIC

LLRLLRFFRRW

εµθ

ππγγσλσλβα

where W is flow compensation in $ thousands, which includes salary, bonus, other annual compensation, long-term incentive plans, restricted stock grants, option grants, and all other compensation. R is the dollar return to shareholders, F(σ2) is the empirical CDF of the variance of dollar returns, LS is financial leverage due to straight debt, and LC equals one is the firm has convertible debt outstanding and zero otherwise. All regressions include 2-digit SIC industry and year fixed-effects (not reported). The t-statistics reported in parenthesis are constructed using bootstrapped standard errors based on 20 replications. ***, **, * means significant at 1%, 5% and 10% respectively. Market leverage Book leverage MR MR 2SLAD 2SLAD (1) (2) (3) (4)

R 0.765 *** 0.897 *** 1.289 *** 1.061 *** (3.11) (7.57) (7.42) (7.60) R*F(σ2) -0.571 ** -0.662 *** -0.984 *** -0.662 *** (2.14) (5.30) (5.62) (4.67) F(σ2) 2,495.269 *** 2,453.364 *** 2,288.589 *** 2,206.424 *** (6.13) (6.73) (28.26) (31.72) R*LS -0.214 * -0.678 *** -0.975 ** (1.67) (2.66) (2.12) LS 281.1384 *** 3,216.465 *** 5,023.959 *** (12.51) (15.63) (12.45) R*LC -0.098 -0.188 0.134 (1.23) (0.76) (0.95) LC 183.365 *** 5,617.696 *** 6,219.868 *** (3.78) (9.63) (12.33) Pseudo R2 0.1906 0.1924 0.2142 0.2138 # Obs. 7,499 7,499 7,499 7,499

32

Table 7 Composition of flow compensation and capital structure

The table reports the mean (median) % share of each component of annual pay on total annual compensation. Flow Compensation = salary + bonus + other annual compensation (short term) + long-term incentive plans (LTIP) + restricted stock grants + option grants + all other compensation (long term). Firms with no convertible debt Leverage Quartiles

Firms with convertible debt

All 1st 2nd 3rd 4th

Salary 40.3 38.0 35.0 39.4 48.9 34.4 (35.6) (32.0) (30.2) (35.7) (45.5) (29.5) Bonus 19.9 20.2 21.8 20.7 16.8 19.0 (19.1) (18.1) (21.2) (20.6) (15.4) (16.6) Other annual 1.3 1.2 1.1 1.3 1.7 1.7 (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) LTIP 4.1 2.0 5.4 4.7 4.2 2.6 (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) Restricted Stock 4.2 3.3 4.2 4.8 4.7 4.6 (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) Stock Options 25.8 31.5 28.4 24.7 18.9 33.4 (21.5) (28.7) (25.6) (21.9) (10.9) (31.0) All Other 4.4 3.8 4.3 4.5 4.8 4.4 (1.5) (1.0) (1.5) (1.8) (1.8) (1.3) # Obs. 5,458 1,876 1,875 1,874 1,874 2,041

33

Table 8 Probit models of annual stock option and restricted stock grants

The table reports the marginal effects for Probit models of the probability that a CEO is granted stock options or restricted stock in that year, respectively. All independent variables correspond to the fiscal year preceding the grant. LS denotes leverage due to straight debt. LC equals one if the firm has convertible debt outstanding, zero otherwise. MTBR is the market-to-book ratio, SIZE is the natural logarithm of the firm’s market capitalization, SALEMP is sales per employee, %R is percentage returns to shareholders, %Var is the variance of percentage returns, TENURE is CEO tenure in years, LN(FLOW) is the natural logarithm of total annual compensation. OWNER and OPTIONS denote the number of shares as a percentage of total shares outstanding and the number of stock options held by the executive as a percentage of total shares outstanding, respectively. All regressions include 2-digit SIC industry and year effects (not reported). Robust t-statistics are reported in parenthesis below each estimate. ***, **, * means significant at 1%, 5% and 10%, respectively. Market Leverage Book Leverage Option Grants Stock Grants Option Grants Stock Grants (1) (2) (3) (4)

LS -0.098 ** 0.110 *** -0.121 *** 0.113 *** (2.35) (2.99) (2.78) (2.92) LC 0.037 ** 0.011 0.034 ** 0.011 (2.43) (0.81) (2.40) (0.81) MTBR -0.005 -0.015 ** -0.003 -0.019 *** (0.92) (2.22) (0.63) (3.00) SIZE 0.029 *** -0.011 * 0.029 *** -0.011 * (4.73) (1.81) (4.90) (1.93) SALEMP -1.41e-07 *** 4.81e-08 -1.38e-07 *** 4.66e-08 (2.80) (1.22) (2.77) (1.18) %R -0.00007 0.00005 -0.00004 0.00003 (0.47) (0.39) (0.26) (0.20) %Var 0.012 ** -0.023 ** 0.012 ** -0.023 ** (2.48) (2.17) (2.44) (2.15) Tenure -0.007 *** -0.003 *** -0.007 *** -0.003 *** (8.51) (3.74) (8.50) (3.80) Ln(FLOW) 0.030 *** 0.061 *** 0.030 *** 0.062 *** (3.27) (8.15) (3.24) (8.23) OWNER -0.009 *** -0.008 *** -0.009 *** -0.008 *** (6.72) (3.64) (6.76) (3.56) OPTIONS 0.003 -0.030 *** 0.003 -0.030 *** (0.63) (4.40) (0.63) (4.43) Pseudo R2 0.1020 0.0763 0.1023 0.0763 # Obs. 7,094 7,094 7,094 7,094

34