“Executive Compensation: The Role of Inside Debt and Vesting Equity in Aligning Incentives and Managing Risk. Part II”

Abstract

This second article examines the effect of CEO inside debt on the myopic nature of firms' decisions. Theory predicts that CEOs with 
higher inside debt reduce the incentive to manage earnings upward, reduce myopic management over time and are observed, anticipated and responded to positively by bond investors. Consistent with these expectations, the results reveal executives with higher inside debt associated with less problematic situations, which may prompt managers to become myopic. Second, inside debt lessens a company's chances of becoming myopic (t+1). Companies with higher debt-to-equity ratios tend to be more long-term oriented and less likely to cut real activity spending. With younger executives and those with long tenures, the negative association becomes more pronounced. Third, inside debt lowers corporate bond yields, demonstrating that bondholders have more trust in companies when executives hold higher debt-to-equity ratios. Inadvertently, inside debt lowers bond yields for bonds with higher risks (e.g., longer maturity and lower credit rating). Multivariate regression results remain significant. Inside debt aligns the long-term incentives of 
managers with those of debt holders, which generally motivates them to utilize less speculative corporate policies and risks.