Is executive compensation a substitute governance mechanism to debt financing and leasing?

ABSTRACT

This study examines whether and how CEO equity incentives relate to financing choices (i.e., debt and leases). Using manually collected CEO compensation and lease data for a sample of large UK firms, we found evidence of a negative relationship between CEO equity incentives and firm leverage. We also found that CEO equity incentives and leases are negatively related. The results are consistent with the theory introduced in this study on the substitutability of executive compensation and firm’s debt/lease financing. Our findings represent fresh empirical evidence and renewed interpretation regarding the relationship between executive equity-based incentives and firm’s financing choices. The substitutability theory we introduced here suggests that firms with greater use of debt and/or leases will implement less equity-based compensation in mitigating the agency cost of equity.

KEYWORDS:

• Executive compensation
• CEO pay
• CEO incentives
• capital structure
• debt
• leasing
• corporate governance

JEL CLASSIFICATION:

• G32
• G34
• J33
• M52

Acknowledgement

We would like to thank anonymous referees and participants at the British Accounting Association (BAA) Annual Conference 2010 in Cardiff (United Kingdom) for comments and suggestions on the earlier version of this paper.

Notes

¹ Although Baltagi (2005, 19) argues that choosing between the fixed effects and random effects estimations ‘is not as easy a choice as it might seem’, a formal Hausman specification test for fixed versus random effects panel estimation is able to identify the estimation method that is suitable for each case in terms of the underlying assumption regarding the error term. The test’s null hypothesis is that the difference in coefficients is not systematic (or random). The random effects estimate is preferred if the null hypothesis cannot be rejected.