Risk-taking incentives and CEOs’ cost-management strategy: evidence from cost-stickiness

ABSTRACT

This research investigates the effect of CEO risk-taking incentives on cost stickiness. By analyzing a comprehensive dataset comprising U.S. public firms from 1993 to 2020, we uncover that higher CEO risk-taking incentives are associated with an increased extent of cost stickiness. Moreover, we observe that this relationship is strengthened under specific conditions, namely when financial leverage is lower, corporate governance is weaker, equity market uncertainty is higher, and real investment opportunities are limited. These findings make a valuable contribution to the relevant literature, highlighting the significance of CEO risk-taking as a potential determinant of cost-related decision-making over resource allocation.

KEYWORDS:

• CEO risk-taking incentives
• stock option vega
• cost stickiness
• asymmetric cost behavior
• CEO compensation

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. While our paper shares common ground with Brüggen and Zehnder’s (2014) study on equity compensation and asymmetric cost behavior, we diverge on key aspects. Unlike their work, we specify that the link between equity compensation and cost stickiness arises from risk-taking incentives, not from pay-performance sensitivity. Furthermore, we view asymmetric cost behavior as potentially ‘suboptimal’ cost management, driven by CEOs’ risk preference, contrasting with Brüggen and Zehnder’s portrayal of ‘optimal’ or interest-aligned cost management. Notably, we interpret asymmetric cost behavior as a risky investment, supported by compelling theoretical arguments (Weiss 2010).

2. The option-vega serves as a widely employed proxy for CEO risk-taking incentives. Following prior literature such as Anantharaman and Lee (2014), Croci and Petmezas (2015), and Dunbar et al. (2020), we use the lagged value of option-vega. The utilization of the previous period’s vega serves to mitigate endogeneity concerns driven by reverse causality or unobservable factors.

3. For example, when CEOs intend to decrease the cost, it could reflect a managerial effort to improve cost efficiency or mitigate the risk of empire-building. Similarly, if CEOs decide to intentionally increase costs, they are less likely to face opposition from monitors or the market as it could be seen as conservative reporting or a method to lower the risk of earnings management.

4. To briefly explain within the context of the relationships among vega, financial leverage, operating leverage, and cost structure, it can be stated as follows: CEOs incentivized by vega favor higher leverage, understanding that increased leverage correlates with greater firm risk. Therefore, if a firm’s inherent capital structure results in low financial leverage, these CEOs are inclined to enhance operating leverage by adopting a stickier cost structure.

5. VEGA is a commonly employed proxy in previous studies investigating executive incentives related to corporate risk-taking (Anantharaman and Lee 2014; Core and Guay 2002; Croci and Petmezas 2015; Dunbar, Li, and Shi 2020; Guay 1999; Hayes, Lemmon, and Qiu 2012; Kim and Lu 2011).

6. For instance, Dunbar et al. (2020) report the mean (standard deviation) of Vega is 0.123 (0.297) while Croci and Petmezas (2015) report 0.130 (0.227) in $million.

7. In untabulated analysis, we repeat the test by using the percentage of institutional ownership (PERC_INSTOWN) as a proxy for corporate governance, and we find the similar findings.

8. In untabulated analysis, we repeat the tests by utilizing the standard deviation of annual stock return by each firm (STD_RET), and we find the similar findings supporting the prediction.