Can the agency costs of debt and equity explain the changes in executive compensation during the 1990s?

Contracting theory predicts that greater equity-related compensation will decrease the agency problems of equity but may exacerbate the agency problems of debt. We present evidence that the agency costs of debt may have declined during the 1990s. Specifically, changes in the financial characteristics of our sample firms suggest that underinvestment, asset substitution, and financial distress became less likely. Furthermore, agency costs of equity increased during the 1990s, primarily because firms became more difficult to monitor. Together, the findings provide an explanation for why more firms used option-based compensation in the latter 1990s, and why the proportion of options in compensation structure increased throughout the decade of the 1990s.     

Agency costs,taxes and debt: The UK evidence

This paper provides an empirical examination of the impact of the corporation tax and agency costs on firms' capital structure decisions. Our evidence suggests that the agency costs are the main determinants of corporate borrowing. Consistent with the agency theory, we find that firms that have fewer growth options have more debt in their capital structure. Moreover, our results show that debt mitigates the free cash flow problem and that firms that are more likely to be diversified and less prone to bankruptcy are highly geared. the negative effect of insider shareholding on leverage disappears, however; when all the agency mechanisms are accounted for. In addition, we find that, in the long run, companies that are tax exhausted exhibit significantly lower debt ratios than tax-paying firms. However, in the short run, firms' capital structure decisions are not affected by taxation.     

Contracting costs and the window of opportunity for straight debt issues

We analyze whether fluctuation in economy-wide factors cause time-series variation in the contracting costs of moral hazard, adverse selection, and financial distress for a sample of straight debt issues. We find that the announcement period abnormal returns to debt issues are more negative in periods of higher interest rates and in industry downturns. When we partition the impact of each issue- and firm-specific measure of contracting costs across high and low levels of each economy-wide variable, we find that only the measures of agency cost are significant in general, and measures of financial distress become relevant for those debt issues that constitute a leverage increase for the firms.     

The Impact of Managerial Entrenchment on Agency Costs: An Empirical Investigation Using UK Panel Data

This paper empirically investigates the relationship between managerial entrenchment and agency costs for a large sample of UK firms over the period 1999–2005. To measure managerial entrenchment, we use detailed information on ownership and board structures and managerial compensation. We develop a managerial entrenchment index, which captures the extent to which managers have the ability and incentives to expropriate wealth from shareholders. Our findings, which are based on a dynamic panel data analysis, show that there is a strong negative relationship between managerial entrenchment and our inverse proxy for agency costs, namely asset turnover ratio. There is also evidence that short‐term debt and dividend payments work as effective corporate governance devices for UK firms. Finally, our findings reveal that agency costs are persistent over time. The results are robust to a number of alternative specifications, including varying measures of managerial entrenchment and agency costs.     

Determinants of Bank Debt in a Continental Financial System: Evidence from Spanish Companies

We test hypotheses about the structure of corporate debt ownership and the use of bank debt by firms in a civil‐law country, Spain. We focus on bank debt effects in the presence of information asymmetries and agency costs, and on efficient versus inefficient firm liquidation. We find that the relation between growth opportunities and bank financing is not as strong as the one found in common‐law countries, that there is a positive relation between firm size and the proportion of bank debt used, and that firms closer to bankruptcy and highly leveraged are more likely to use bank debt.     

CAPITAL STRUCTURE,SHAREHOLDER RIGHTS,AND CORPORATE GOVERNANCE

We show how capital structure is influenced by the strength of shareholder rights. Our empirical evidence shows an inverse relation between leverage and shareholder rights, suggesting that firms adopt higher debt ratios where shareholder rights are more restricted. This is consistent with agency theory, which predicts that leverage helps alleviate agency problems. This negative relation, however, is not found in regulated firms (i.e., utilities). We contend that this is because regulation already helps alleviate agency conflicts and, hence, mitigates the role of leverage in controlling agency costs.     

THE INFLUENCE OF FIRM‐ AND CEO‐SPECIFIC CHARACTERISTICS ON THE USE OF NONLINEAR DERIVATIVE INSTRUMENTS

We examine why firms use nonlinear derivatives (e.g., options). Our results suggest that option characteristics in investment opportunities and debt, the payoff structure of incentive compensation, and free cash‐flow agency problems influence the firm's choice. Investment opportunities, internally generated cash flow, business risk, and option compensation positively influence the use of nonlinear currency derivatives. Option feature in bonds positively influence the use of nonlinear interest rate derivatives, whereas bonus and stock compensation, and CEO tenure have a negative influence. In sum, nonlinear cash flow characteristics in investment opportunity, debt, and executive compensation all relate positively to nonlinear derivative usage.     

Geographic diversification and agency costs of debt of multinational firms

This paper examines the agency conflicts between shareholders and bondholders of multinational and non-multinational firms and provides an explanation for the puzzle that multinational firms use less long-term debt, but more short-term debt than domestic firms. Using a sample of 6951 firm–year observations for multinational and domestic firms over the 1988–1994 period, we find that alternative measures of agency costs have statistically significant negative effects on the firm's long-term leverage. The results, however, also show that the negative effects of agency costs of debt on long-term leverage are significantly greater for multinational than non-multinational firms. It is documented that the effect of the agency costs of debt on leverage are increased by the firm's degree of foreign involvement. The evidence shows that firm's increasing foreign involvement exacerbates agency costs of debt leading to lower (greater) use of long-term (short-term) debt financing. This result is also confirmed using alternative measures of foreign involvement. The evidence is consistent with the view that multinational corporations (MNCs) are susceptible to higher agency costs of debt than domestic corporations because geographic diversity renders active monitoring more difficult and expensive in comparison to domestic firms. The results fail to support the view that MNCs' lower long-term debt ratios are due to the advantages of the internal capital markets.     

Determinants of stock option use by Japanese companies

Japanese data show a negative relation between leverage and the probability of firms' use of stock options. Such a relation is more marked for firms affiliated with specific keiretsu or main banks. This evidence reflects the fact that Japanese companies are more reliant on debt financing and that the agency cost of debt is a central issue in corporate governance. Results show that the frequency of the firms' use of stock options is positively associated with firm size. Finally, independent firms, which reveal more concern about shareholder wealth, are more likely to use stock options.     

Managerial risk incentives and investment related agency costs

We assess the impact of compensation based incentives together with monitoring mechanisms on investment related agency costs. The results indicate that well structured compensation based incentives significantly reduce agency costs. Managerial firm based wealth delta has a significant, negative effect on agency costs for firms in all size categories. The significance of managerial firm based wealth vega in reducing agency costs is concentrated in small firms, suggesting that vega exposure is more effective where risk is higher. The significance of cash compensation in reducing agency costs is concentrated in the large firms. This result implies that higher cash compensation reduces agency costs by allowing risk-averse managers the opportunity to diversify outside the firm.     

Product market competition and the cost of bank loans: Evidence from state antitakeover laws

The extant literature documents a positive relationship between a firm’s takeover vulnerability and its agency cost of debt. Using state antitakeover laws as an exogenous measure of variation in takeover vulnerability, I investigate whether product market competition has a disciplinary effect that can lower a firm’s cost of bank loans. After taking into account the industry composition of borrowers, I find that banks charge higher spreads to borrowers that are vulnerable to takeovers, but only in concentrated industries. In the absence of disciplinary competitive pressure, the effect of takeover vulnerability on the cost of bank loans is mitigated for larger firms, firms followed by analysts, firms with existing credit ratings, non-family firms, and for borrowers with shorter maturity loans or loans with covenants and collateral in place. Taken together, the results suggest that the effect of governance on the cost of financing is not homogenous across all industries, and that concentrated industry firms may need to use supplementary governance mechanisms to mitigate debt holder agency problems.     

CEO Compensation Risk and Timely Loss Recognition

Prior studies demonstrate that high CEO compensation risk encourages managers to engage in risk‐seeking behavior, thus intensifying agency conflicts between creditors and borrowers. We argue and document that accounting conservatism plays an important role in mitigating debt holder and shareholder conflicts over asset substitution arising from high CEO compensation risk. Our empirical results show that firms with high CEO compensation risk tend to use more timely loss recognition and this positive relationship is more pronounced for firms with high leverage. Additional results show that the positive relationship between CEO compensation risk and borrowing costs is reduced for firms using timely loss recognition, suggesting that creditors perceive timely loss recognition as a risk‐reducing mechanism. Using the passage of FAS 123R as a quasi‐natural experiment on managerial compensation risk, we find a significant reduction in the use of timely loss recognition for firms experiencing a decrease in CEO compensation risk after the passage of FAS 123R. Lastly, we show that timely loss recognition is positively associated only with the compensation risk of the firm's primary decision maker (i.e., its CEO) and not with the compensation risk of subordinates.     

The determinants of debt maturity in Australian firms

We examine the determinants of debt maturity in the Australian capital market with the Top 400 firms listed on the Australian Securities Exchange for the period 1989–2006. We find that Australian firms not only exhibit a positive leverage–maturity relationship but also use short‐term debt to signal their high quality to the market. Our results are robust to different estimation methods that control for endogeneity and error‐dependence. We also find that ignoring the interaction between leverage and maturity can lead to erroneous conclusions about the support for the matching principle, the agency costs hypothesis and the transaction costs hypothesis.     

Real options and earnings-based bonus compensation

This study extends the works of Mauer and Sarkar (2005) and Andrikopoulos (2009) by incorporating a regime-dependent earnings-based bonus into managerial compensation. Examining the individual effects of ownership shares and earnings-based bonus compensation, we find that the former provides managers with incentives to issue debt, whereas the latter induces the opposite result, although consistent impacts are found for the two types of compensation on both agency costs and the optimal investment decisions of managers. When managerial compensation comprises both ownership shares and an earnings-based bonus, there are significant differences in the effects of these two types of performance compensation on managers’ optimal investment and financing decisions, agency costs, optimal debt ratios and credit spreads, as a result of the specific interactions between the investment and financing decisions.     

Are Debt and Incentive Compensation Substitutes in Controlling the Free Cash Flow Agency Problem?

This paper investigates the governance implications of a firm's capital structure and managerial incentive compensation in controlling the free cash flow agency problem. The results suggest: debt and executive stock options act as substitutes in attenuating a firm's free cash flow problem; failure to incorporate the substitutability and endogeneity leads to underestimates of the magnitude and economic implication of the disciplinary role of both mechanisms; firm characteristics differ across the prevalence of debt usage versus option usage, suggesting the heterogeneity in the costs and benefits of the monitoring devices; and all the above effects are more pronounced in firms that tend to have more severe agency problem.     

Board quality and the cost of debt capital: The case of bank loans

We analyze the relation between comprehensive measures of board quality and the cost as well as the non-price terms of bank loans. We show that firms that have higher quality boards with a greater advisory presence borrow at lower interest rates. This relation exists even after controlling for ownership structure, CEO compensation policy, and shareholder protection, as well as the size and financial characteristics of the borrower and of the loan. We also show evidence that board quality and other governance characteristics influence the likelihood that loans have covenant requirements, but the relations differ by covenant type. When we combine the direct and indirect costs of bank loans we find that firms with large, independent, experienced, and diverse boards and lower institutional ownership borrow more cheaply. Overall, the evidence indicates that board quality impacts the cost of bank debt.     

Corporate Pyramids,Conservatism and Cost of Debt: Evidence From Taiwan

This study investigates the extent to which the span of corporate pyramids (as measured by the number of ownership layers) is associated with higher agency costs of debt, and whether conservatism can moderate the agency cost. Consistent with corporate pyramids generating higher agency costs and information asymmetries between corporate insiders and outside creditors, we find a positive association between the number of investment layers and cost of debt. However, we also find that multi-layered firms mitigate organizational opaqueness through increased financial reporting conservatism, which results in lower cost of debt capital. These findings provide new insights into the relationship between organizational structure and financial reporting quality.     

‘Hot’ Debt Markets and Capital Structure

This paper examines the motives of debt issuance during hot‐debt market periods and its impact on capital structure over the period 1970–2006. We find that perceived capital market conditions as favourable, an indication of market timing, and adverse selection costs of equity (i.e., information asymmetry) are important frictions that lead certain firms to issue more debt in hot‐ than cold‐debt market periods. Using alternative hot‐debt market issuance measures and controlling for other effects, such as structural shifts in the debt market, industry, book‐to‐market, price‐to‐earnings, size, tax rates, debt market conditions and adjustment costs based on debt credit ratings, we find that firms with high adverse selection costs issue substantially more (less) debt when market conditions are perceived as hot (cold). Moreover, the results indicate that there is a persistent hot‐debt market effect on the capital structure of debt issuers; hot‐debt market issuing firms do not actively rebalance their leverage to stay within an optimal capital structure range.     

On the value of restrictive covenants: Empirical investigation of public bond issues

Are restrictive covenants effective mechanisms in mitigating agency problems? Is the magnitude of the increase in the cost of debt due to agency problems non-trivial? We tackle these questions using a large dataset of public bonds. Contrary to the view that restrictive covenants in public bond contracts are standard boilerplates that serve little purpose, we find significant benefits in terms of reduction in the cost of debt associated with covenants. Restrictions on investment activities or issuance of higher priority claims reduce the cost of debt by about 35–75 basis points. These findings suggest that investors view bond covenants as important instruments in mitigating agency problems, and an increase in the cost of debt due to agency problems could be substantial. Additionally, we find that high growth firms and firms with low probability of default are less likely to include covenants suggesting that the costs of covenants outweigh benefits for these types of firms.     

Multiple corporate governance attributes and the cost of capital – Evidence from Germany

This paper investigates the extent to which corporate governance affects the cost of debt and equity capital of German exchange-listed companies. I examine corporate governance along three dimensions: financial information quality, ownership structure and board structure. The results suggest that firms with high levels of financial transparency and bonus compensations face lower cost of equity. In addition, block ownership is negatively related to firms' cost of equity when the blockholders are other firms, managers or founding-family members. Consistent with the conjecture that agency costs increase with firm size, I find significant cost of debt effects only in the largest German companies. Here, the creditors demand lower cost of debt from firms with block ownerships held by corporations or banks. My findings demonstrate that a uniform set of governance attributes is unlikely to satisfy suppliers of debt and equity capital equally.