Optimal compensation contracts when managers can hedge

This paper examines optimal compensation contracts when executives can hedge their personal portfolios. In a simple principal-agent framework, I predict that the Chief Executive Officer's (CEO's) pay-performance sensitivity decreases with the executive-hedging cost. Empirically, I find evidence supporting the model's prediction. Providing further support for the theory, I show that shareholders also impose a high sensitivity of CEO wealth to stock volatility and increase financial leverage to resolve the executive-hedging problem. Moreover, executives with lower hedging costs hold more exercisable in-the-money options, have weaker incentives to cut dividends, and pursue fewer corporate diversification initiatives. Overall, the manager's ability to hedge the firm's risk affects governance mechanisms and managerial actions.     

Payout flexibility and capital expenditure

Over the past two decades or so, repurchases have become an appealing method for disbursing cash to shareholders compared to the traditional dividends. Managerial perception as well as empirical evidence suggests that repurchases are inherently more flexible than dividends, which may account for their increasing popularity. The rigidity of dividends and the apparent flexibility of share repurchases could impact firm investments. Firms may forego profitable investment opportunities to maintain their dividend levels, while repurchases could be easily scaled back to fund profitable investment projects without fear of an adverse market reaction. We test the flexibility hypothesis of repurchases by regressing capital expenditures on repurchases and dividends in addition to other control variables. Consistent with our hypotheses, we find an inverse relationship between capital expenditures and repurchases but an insignificant relationship with dividends. Further, we find that the flexibility associated with repurchases is especially evident for firms that are financially constrained, and during the recent financial crisis period when external capital constraints were severe. Finally, we find that flexibility of repurchases with respect to capital expenditures is stronger in the more recent time period during which regulatory changes made repurchases more attractive as a mechanism to disburse cash back to shareholders.     

Payout policy and cash-flow uncertainty

The importance of cash-flow uncertainty in payout policy has received little attention in empirical studies, while survey studies such as [Lintner, J., 1956. Distribution of incomes of operations among dividends, retained earnings, and taxes. American Economic Review 46, 97–113.] and [Brav, A., Graham, J., Harvey C., Michaely, R., 2005. Payout policy in the 21st century. Journal of Financial Economics 77, 483–527.] indicate its importance. With worldwide firm-level data, we present evidence that cash-flow uncertainty is an important cross-sectional determinant of corporate payout policy. Our results show that across countries, cash-flow uncertainty, as proxied by stock return volatility, has a negative impact on the amount of dividends as well as the probability of paying dividends. The impact of cash-flow uncertainty on dividends is generally stronger than the impact of other potential determinants of payout policy—such as the earned/contributed capital mix, agency conflicts, and investment opportunities. We also find that the effect of cash-flow uncertainty on dividends is distinct from the effect of a firm's financial life-cycle stage.     

A model of dynamic compensation and capital structure

This paper studies the optimal compensation problem between shareholders and the agent in the Leland (1994) capital structure model, and finds that the debt-overhang effect on the endogenous managerial incentives lowers the optimal leverage. Consistent with data, our model delivers a negative relation between pay-performance sensitivity and firm size, and the interaction between debt-overhang and agency issue leads smaller firms to take less leverage relative to their larger peers. During financial distress, a firm's cash flow becomes more sensitive to underlying performance shocks due to debt-overhang. The implications on credit spreads and debt covenants are also considered.     

Payout policy and ownership structure: The case of Islamic and conventional banks

Using a sample of Islamic and conventional financial institutions domiciled in 16 countries for the period 2000–2015, we examine how ownership structure affects dividend policy. Our main findings indicate that ownership identity is important in explaining dividend policy in these banks, albeit in different patterns. In particular, the results suggest that government ownership seems to exert negative effects on dividend payouts in both types of banks, which is in line with the preference of governments towards bank stability. With respect to family ownership, the impact is negative for conventional banks but positive for Islamic ones, consistent with agency theory. These results are to some extent similar in the case of foreign ownership where it is associated with a higher payout policy in Islamic banks, but not significant in conventional ones. Our results are robust to an array of additional analyses including propensity score matching.     

Carbon policy risk and corporate capital structure decision

This study examines the relationship between carbon policy risk and corporate capital structure in China. Using a sample of A-share listed firms from 1997 to 2018, we find that carbon policy risk reduces firms' financial leverage. The result is robust to the introduction of difference-in-differences tests, instrumental variable regression, and a placebo test used to address endogeneity, as well as to other tests of alternative measures. This negative relationship is more pronounced for non-state-owned enterprises, firms with low institutional investor ownership, firms with poor corporate social responsibility performance, firms belonging to competitive or carbon-sensitive industries, and firms located in provincial cities. Financing constraints, bankruptcy risk, and government power are potential mechanisms underlying this observation. Our findings provide practical suggestions through which firms can address carbon policy risk and provide guidance to governments and regulators for the further implementation of environmental policies.     

Payout policy,financial flexibility,and agency costs of free cash flow

This paper explains how firms choose between dividends and open-market repurchase programs, the prevailing method that firms use to disburse cash today. While earlier theories about payout policy are motivated by signaling, the motivation for payout in this paper is to prevent the waste of free cash by self-interested insiders. In the model, dividends prevent free cash waste by forcing cash out, but result in underinvestment if the cash paid out is later needed for operations. Open-market programs stimulate payout by providing personal gains to informed insiders that are associated with the firm's repurchase trade. Yet, they also avoid the underinvestment problem by leaving insiders the option to cancel the payout. Because their execution is optional, however, open-market programs only partially prevent the waste of free cash. The model provides testable predictions that are generally consistent with the empirical evidence.     

Monetary policy,government control and capital investment: Evidence from China

This study examines how the relationships between local governments and local enterprises moderate the effect of targeted monetary policies through different action-propagating mechanisms. First, we investigate the impact of monetary policies on enterprise investment in areas with different institutional environments. Second, we investigate the impact of monetary policies on state-owned enterprises (SOEs) with different property rights structures. Third, we examine how political connections can influence the action-propagating mechanism of monetary policies. We conclude that in China monetary policies have different effects on SOEs and on private enterprises with or without political connections. Specifically, local government interventions can significantly weaken and distort the effects of monetary policies, such that the intended reduction in investment is noticeably alleviated for SOEs and private enterprises with close links to local governments.     

Geographical relationships and CEO compensation contracts

In this paper, we empirically analyze the effects that the geographical relationships between chairman and CEO have on the latter’s compensation contracts,based...     

Human capital,pay structure,and the use of performance measures in bonus compensation

Traditional financial measures have been criticized for lacking relevance in today's economy where firms are increasingly competing with intangible assets. However, perhaps this criticism is not detrimental to firms if they take actions to supplement the information contained in financial measures. Thus, it is important to explore whether and when firms recognize this potential deficiency and take action to acquire the appropriate information. This study hypothesizes that two human resource variables, reliance on human capital and the firm's pay structure, are associated with the use of non-financial measures in top managers’ bonus compensation contracts since they provide information incremental to that provided by traditional financial measures. Using archival data from 177 firms, I estimate binary and multi-response ordered logit models. The binary logit model provides evidence that labor-intensive firms have a higher probability of placing emphasis on non-financial measures (along with traditional financial measures) and a lower probability of relying solely on traditional financial measures. Moreover, this relationship is moderated by the firm's pay structure. Analysis shows that the relationship is stronger in firms that employ a hierarchical pay structure. Furthermore, the multi-response logit model extends these finding by showing that these firms also have a higher probability of relying on human resource measures.     

Labor contracts and monetary policy

Fischer and others have shown that the very existence of long-term contracts can imply a stabilization role for monetary policy in models that incorporate the natural rate hypothesis and rational expectation formation. The present paper examines some of the factors that determine the length of labor contracts and how they are affected by monetary policy. It is argued that a successful stabilization policy might be expected to increase the length of contracts. The net effect of the imposition of such a policy would therefore be to dampen the amplitude of business cycles, but to make them more inertia ridden.     

Outsourcing with long term contracts: capital structure and product market competition effects

This paper analyzes how capital structure and product market competition affect the firms’ strategic choice between outsourcing with long term contracts and outsourcing to the spot market. When outsourcing to the spot market firms are exposed to price uncertainty, whereas a long term contract allows them to set in advance the outsourcing price. We show that, to the extent that leverage and uncertainty can lead to financial distress costs in bad states of nature, firms may use long term contracts as a risk management device to hedge input price uncertainty. With a monopoly in the final product market, the outsourcing decision involves a trade-off between a positive convexity effect of input price uncertainty under the spot regime and the option to avoid financial distress costs under the long term contract regime. Moreover, product market competition among buyers can lead to an increase in financial distress costs not only for firms outsourcing to the spot market but also for firms outsourcing with a long term contract. We examine the monopolist’s outsourcing decision and derive the equilibrium for an oligopoly, and show that the equilibrium depends on the magnitude of these costs and on the level of efficiency of the supplier.     

Aligning managed care contracts, compensation plans, and incentive models

Today's pure production-based compensation and incentive models are lagging behind new, third-party, "value based" payment models, such as shared savings, bundled payments, and pay for performance. Financial executives are struggling with the emerging disconnects between new, external payment models and traditional methods providers use to distribute funds internally. To begin to align internal payment models with emerging third-party payment models, providers should inventory the misaligned incentives within their own organizations, engage their physicians and payers in a dialogue on what needs to be paid and how, and learn from past mistakes. No perfect payment distribution model exists. Rather, providers should choose a best-fit model based on their market position, culture, and readiness for change. Ultimately, finance executives should take the lead in aligning their organization's internal and external payment models.     

Required return on equity when capital structure is dynamic

We link the firm's required return on equity to its target debt ratio. We find that a firm's expected return on equity is increasing in the product of the distance between its debt ratio and its target debt ratio, its speed of adjustment, and the spread of the tax benefits of its debt over its bankruptcy costs of debt. Our empirical tests validate the testable implications of our model.     

Payout policy and the interaction of firm-level and country-level governance

Review of Quantitative Finance and Accounting - For a panel of 1880 firms across 21 countries from 2004 to 2008, the impact of firm-level and country-level governance on payout policy is consistent...     

Payout policy,taxes, and the relation between returns and the bid–ask spread

Recent evidence demonstrates that corporate payout policy has shifted from the nearly exclusive use of dividend payout to the inclusion of stock repurchase, primarily through open markets. This trend has been attributed to the tax advantages associated with repurchase relative to dividends. In this paper, we introduce personal taxation and stock repurchase to reexamine the relation between returns and the bid–ask spread. Our model provides insight into the nature of this relation. Tests performed using NYSE, AMEX, and NASDAQ data provide empirical support of our theoretical conclusions. We conclude that the firm’s choice of payout policy influences the relation between returns and spreads.     

The design of internal control and capital structure

We study the design of internal control and capital structure.We pose the question, When is control allocated only to shareholdersand when is it allocated to other stakeholders, such as debtholders,or the management team? We show that shareholders (debtholders)get control when the firm's cash flow is relatively sensitive(insensitive) to managerial effort. Our theory implies thatthe signs of the correlations between endogenous variables whenshareholders have absolute control are reversed when debtholdershave veto power. In particular, debt level and firm value arenegatively (positively) correlated when debtholders have vetopower (shareholders have absolute control).     

Bank capital,interbank contagion,and bailout policy

This paper develops a theoretical framework in which asset linkages in a syndicated loan agreement can infect a healthy bank when its partner bank fails. We investigate how capital constraints affect the choice of the healthy bank to takeover or liquidate the exposure held jointly with the failing bank, and how the bank’s ex ante optimal capital holding and possibility of contagion are affected by anticipation of bail-out policy, capital requirements and the joint exposure. We identify a range of factors that strengthen or weaken the possibility of contagion and bailout. Recapitalization with common stock rather than preferred equity injection dilutes existing shareholder interests and gives the bank a greater incentive to hold capital to cope with potential contagion. Increasing the minimum regulatory capital does not necessarily reduce contagion, while the requirement of holding conservation capital buffer could increase the bank’s resilience to avoid contagion.     

Subsidiary debt,capital structure and internal capital markets

I study external debt issued by operating subsidiaries of diversified firms. Consistent with Kahn and Winton's [2004. Moral hazard and optimal subsidiary structure for financial institutions. Journal of Finance 59, 2537–2575] model, where subsidiary debt mitigates asset substitution, I find firms are more likely to use subsidiary debt when their divisions vary more in risk. Consistent with subsidiary debt mitigating the free cash flow problem, I find that subsidiaries are more likely to have their own external debt when they have fewer growth options and higher cash flow than the rest of the firm. Finally, I find that subsidiary debt mitigates the “corporate socialism” and “poaching” problems modeled in theories of internal capital markets.