CEO Incentives and the Cost of Debt

Transcription

1 CEO Incenives and he Cos of Deb Kenneh W. Shaw Universiy of Missouri-Columbia ABSTRACT Moivaed by concerns ha sock-based compensaion migh lead o excessive risk-aking, his paper examines he relaions beween CEO incenives and he cos of deb. Unlike prior research, his paper uses he sensiiviies of CEO sock and opion porfolios o sock price (dela) and sock reurn volailiy (vega) o measure CEO incenives. Higher dela (vega) is prediced o be relaed o less (greaer) risk-seeking, and hus lower (higher) cos of deb. The resuls show ha yield spreads on new deb issues are lower for firms wih higher CEO dela, and are unrelaed o CEO vega. While yield spreads are higher for firms whose CEOs hold more shares and opions, a sample firm a he 3 rd quarile level of each of his sudy s CEO incenive variables would expec an esimaed 26 basis poin reducion in yield spread on a new deb issue, relaive o a sample firm a he median level of he CEO variables. In sum, CEO incenives are relaed o a lower cos of deb. Helpful commens from workshop paricipans a he Universiy of Missouri and he American Accouning Associaion naional meeing (Chicago) Midwes Regional meeing (S. Louis) are appreciaed.

2 CEO Incenives and he Cos of Deb 1. Inroducion Sock-based CEO compensaion and deb financing are ubiquious in modern capial markes. Sock-based pay makes CEO wealh sensiive o sock reurn volailiy and o movemens in he underlying sock price, bu, as noed by several auhors (e.g., Lamber, Larcker, and Verrecchia 1991; Carpener 2000; Knopf, Nam, and Thornon 2002; Coles, Daniel, Naveen 2006), hese sensiiviies imply compeing effecs on CEO s risk-seeking: sensiiviy o sock reurn volailiy (share price) moivaes more (less) risky invesmens. 1 The relaions beween hese sensiiviies and risk-seeking in urn imply compeing effecs of sock-based CEO compensaion on he cos of deb; ceeras paribus, CEO wealh more sensiive o sock reurn volailiy (share price) should be relaed o higher (lower) cos of deb. This paper examines how yield spreads on new deb issues are relaed o he sensiiviies of CEO sock and opion compensaion porfolios o sock price and sock reurn volailiy. This issue is imporan. Firs, deb is a widely-used form of financing, and evidence suggess lenders are aware of a poenial relaion beween CEO incenive compensaion and heir risk-seeking behavior. For example, Moody s (2003) argues ha execuive pay arrangemens ha provide large shor-erm incenives paricularly hose relaed o equiy valuaions, may pose excessive risk, paricularly from a credi sandpoin. However, he relaion beween CEO dela and vega and he cos of deb remains unexplored. Second, sock-based compensaion is designed in par o encourage risk-averse and under-diversified managers o inves in risky bu posiive ne presen value projecs. 1 Sensiiviy o reurn volailiy (sock price) is also commonly referred o as vega (dela). 2

3 While poenially beer aligning managers ineress wih hose of shareholders, sockbased compensaion migh encourage excessive risk-aking, hus aggravaing sockholder-debholder conflics (John and John 1993; Parrino and Weisbach 1999). Alernaively, research also suggess sock-based compensaion migh no increase CEO risk-seeking (Carpener 2000; Ross 2004; Hanlon, Rajgopal, and Shevlin 2004). Examining he relaion beween CEO dela and vega and he cos of deb provides insighs ino debholders assessmen of he link beween CEO sock-based compensaion and heir firms risk-aking. Third, exan research on he relaions beween opion compensaion and deb coss ypically uses eiher he exisence of an opion plan or he number of opions held by managers o proxy for managerial incenives. For example, DeFusco, Johnson, and Zorn (1990) documen a negaive bond price reacion o he announcemen of adopion of a managerial sock opion plan for a sample of firms over Oriz-Molina (2006) finds a posiive relaion beween he yield spread on new deb issues and he number of opions held by he firm s op five managers. Imporanly however, he managerial incenive measures used in hese and relaed sudies fail o exploi poenial cross-secional variaion in sock-based incenives ha arise from, for example, differen opion imes o mauriy or exercise prices. Research suggess ignoring hese poenial sources of cross-secional variaion in CEO incenives can lead o misleading inferences. In conras o resuls in DeFusco e al (1990), Bille, Mauer, and Zhang (2006) find a posiive (negaive) marke reacion o he dela (vega) of firs-ime grans of opion compensaion o CEO s over Knopf e al (2002) iniially find a posiive relaion beween he number of opions held by 2 These resuls are mos pronounced for firms wih relaively low levels of managerial share ownership. 3

4 he CEO and his firm s use of derivaives, bu hen find a negaive (posiive) relaion beween CEO vega (dela) and he use of derivaives. Tess incorporaing CEO dela and vega address hese poenially compeing effecs, and hus enable insighs beyond hose available from using more crude proxies for CEO incenives. The sample includes 598 new deb issues by 274 disinc S&P 1500 firms over I use he Core-Guay (2002) mehod of esimaing opion sensiiviies o beer undersand he relaion beween CEO incenives and he cos of deb. 3 This approach uses one year of proxy saemen daa, along wih some reasonable assumpions on imes o mauriy and exercise prices for previously graned opions, o exploi he cross-secional variaion in CEO sock opion porfolios and hus beer capure CEO incenives. This mehod yields esimaes of he separae sensiiviies of CEO porfolios o sock price (dela) and sock reurn volailiy (vega). I hen empirically examine he relaions beween yield spreads on new deb issues, he sensiiviies of CEO sock and opion porfolios o sock price and sock reurn volailiy, and conrol variables. These analyses provide new insighs ino he relaion beween sock-based CEO compensaion and he cos of deb. Firs, he more sensiive he CEO s wealh is o share price, he lower is he yield spread on new deb issues. In sark conras o resuls in Oriz-Molina (2006), bu consisen wih heory in Carpener (2000) and Ross (2004), sock-based incenives do no unambiguously lead o higher cos of deb. Second, he sensiiviy of he CEO s sock and opion porfolio o sock reurn volailiy has lile impac on he cos of deb. This is consisen wih large-sample evidence in Hanlon e al (2004), who find lile effec of vega on subsequen sock reurn volailiy. Third, afer 3 Oher sudies ha use he Core-Guay (2002) approximaion include Knopf e al (2002), Rajgopal and Shevlin (2002), Bergsresser and Philipon (2006), Bille e al (2006), Cheung and Warfield (2005), Burns and Kedia (2006), Erickson, Hanlon, and Maydew (2006), and Hanlon, Rajgopal, and Shevlin (2004). 4

5 including CEO dela and vega, CEO opion and share holdings remain posiively relaed o he cos of deb, suggesing hese ownership variables capure, a leas o some exen, CEO incenives for risky invesmens. These resuls are robus o inclusion of a long lis of conrol variables, including conrols for oher feaures of corporae governance; a baery of design feaures and ess o address he poenial impac of endogeneiy on he resuls, including use of year -1 explanaory variables, Wu-Hausman ess for endogeneiy, wo-sage leas squares esimaion, and a changes specificaion. The resuls are also robus o alernaive measures of he cos of deb. Overall, he resuls sugges CEO sock-based incenives reduce he cos of deb. The effecs of CEO incenives on he cos of deb are also economically significan; a sample firm a he 3 rd quarile level of his sudy s CEO variables would expec an esimaed 26 basis poin reducion in he yield spread on a new deb issue, relaive o a sample firm a he median level of he CEO variables. This is comparable o evidence in Anderson, Mans and Reeb (2003, deb coss are abou 32 basis poins lower in firms wih founding family ownership han in firms wihou founding family ownership), and Klock, Mans and Maxwell (2005, deb coss are abou 30 basis poins lower for firms wih high aniakeover provisions versus firms wih low aniakeover provisions). This paper provides several conribuions. Firs, o my knowledge his is he firs paper o examine he relaion beween CEO incenives, measured by sensiiviy o share price and sock reurn volailiy, and he cos of deb financing. Debholders perspecive is imporan, given he wide use of deb financing and debholders concern wih shareholders expropriaing wealh via risky invesmens (Jensen and Meckling 1976; John and John 1993; Parrino and Weisbach 1999). Tess employing dela and vega 5

6 enable a more complee undersanding of he link beween CEO sock-based incenives and he cos of deb han is available wih more crude proxies for CEO incenives. The paper also conribues o research on he incenive effecs of CEO sockbased compensaion. While ofen maligned, opions remain imporan in compensaion plans, and a growing body of evidence suggess benefis from opion plans. For example, Hanlon, Rajgopal, and Shevlin (2003) find a posiive relaion beween sock opion usage and fuure earnings. Knopf e al (2002) find a ne posiive effec of opion plans on risk hedging wih derivaive insrumens. Balsam and Miharjo (2007) find ha greaer use of opion compensaion is relaed o lower levels of volunary CEO urnover, paricularly among he sronges-performing CEOs. The resuls in his paper sugges a ne benefi, in he form of lower cos of deb on new issues, from CEO opion compensaion plans. The remainder of his paper is organized as follows. Secion 2 discusses relaed research and develops his paper s hypoheses, Secion 3 describes sample selecion and variable measuremen, and Secion 4 discusses he empirical model. Secion 5 presens he resuls and Secion 6 concludes. 2. Relaed Research and Hypoheses 2.1 ANALYTICAL RESEARCH Agency conflics beween firm managers and ouside shareholders have long been recognized (e.g., Berle and Means 1932). Generally, CEOs prefer less risk han do more well-diversified ouside shareholders. Sock-based compensaion arguably aligns managers incenives wih hose of ouside shareholders, and hus induces managers o ake firm-value increasing acions. Jensen and Meckling (1976) and Smih and Sulz (1985) argue ha compensaion payoffs ha are a convex funcion of share price are 6

7 needed o miigae managers endencies owards risk-aversion and encourage hem o inves in risky bu posiive ne presen value projecs. Oher analyical research however suggess he mere exisence of a sock-based compensaion plan need no encourage managerial risk-seeking behavior. Lamber e al (1991) employ a single-period model in which a manager s pay for he period is based on performance for ha period. Their resuls sugges ha if a risk-averse manager has a sizable porion of his oher wealh ied o his firm s sock price, he values he incenive compensaion conrac less han is cos as perceived by shareholders. Lamber e al (1991) also show ha an incenive sock opion conrac does no necessarily provide a risk-averse manager wih incenives o ake acions ha increase he variabiliy of sock price. In an ineremporal model, Carpener (2000) models how a risk-averse manager adjuss o a convex compensaion scheme. Carpener (2000) shows ha opion compensaion does no sricly lead o greaer risk-aking, and under cerain assumpions leads he manager o prefer less risk-aking. Ross (2004) sums up his lieraure by saing The common folklore ha giving opions o agens will make hem more willing o ake risks is false. In sum, exan heory presens compeing predicions on how incenive compensaion should impac CEOs risk-seeking behavior. 2.2 EMPIRICAL RESEARCH Lamber e al (1991) sugges ha measuring he parial derivaive (or, sensiiviy) of he change in manager compensaion wih respec o a change in a performance variable is he preferred way o assess managers incenives. Recen empirical research 7

8 examines he relaions beween CEO sock and opion porfolio sensiiviies and firms invesmen decisions. Guay (1999) finds ha he sensiiviy of CEO wealh o sock reurn volailiy is posiively relaed o he firm s growh opporuniies, consisen wih firms providing managers incenives o inves in risky projecs when heir risk-aversion migh oherwise cause hem o forgo risky bu posiive ne presen value projecs. Rajgopal and Shevlin (2002) find ha greaer sensiiviy of CEO wealh o sock reurn volailiy is relaed o greaer exploraion risk, and less risk hedging, for a sample of oil and gas firms. Knopf e al (2002) find ha as he sensiiviy of CEO s sock and opion porfolios o sock price (reurn volailiy) increases, firms hedge more (less) hrough derivaives. Hanlon e al (2004) find ha CEO opion porfolios more sensiive o sock reurn volailiy are associaed wih greaer one-year ahead sock reurn volailiy, hough he effecs are economically small. Finally, Coles e al (2006) find ha greaer sensiiviy of CEO wealh o sock reurn volailiy is relaed o greaer research and developmen expendiures and less capial expendiures. 2.3 HYPOTHESES The analyical research above provides compeing predicions on how sock-based compensaion impacs risk-seeking, and suggess he need o examine deailed feaures of CEO opions. The empirical research above suggess CEO dela and vega are relaed o firms invesmen decisions. In seing yield spreads on new deb issues, lenders can be expeced o raionally consider he impac of incenive compensaion on CEOs riskseeking behavior (e.g. Moody s 2003; Jensen and Meckling 1976; Parrino and Weisbach 1999). Thus, feaures of CEO compensaion conracs ha encourage risk-seeking 8

9 behavior should be relaed o coslier deb, while CEO compensaion conrac feaures ha encourage risk-hedging and/or less risky invesmens should be relaed o less cosly deb. This leads o his sudy s wo hypoheses, saed in alernae form: H 1 : The cos of deb is inversely relaed o he sensiiviy of CEO wealh o share price. H 2 : The cos of deb is posiively relaed o he sensiiviy of CEO wealh o sock reurn volailiy. While heory does no provide an unambiguous predicion as o he overall impac of CEO sock-based incenives on he cos of deb, his sudy s analyses, incorporaing a myriad of CEO variables, provides insigh ino his overall impac. 3. Sample Selecion and Daa 3.1 SAMPLE SELECTION Sample selecion begins wih firms wih CEO sock opion daa on Sandard and Poor s Execucomp in any of he years Firms lacking Compusa, CRSP, or CDA/Specrum daa needed o compue conrol variables (see secion 3.4) are deleed. The SDC Global New Issues daabase is hen used o obain a lis of fixed-rae deb issues by hese firms over If a firm makes muliple deb issues in a given year he firs such issue is used for ha firm-year. Using he firs issue of he year mos closely maches he iming of he yield spread daa wih he CEO porfolio daa, which are 4 Firms wihou opions held by heir CEO s are excluded from he sample. 5 The regressions (see secion 4) use lagged values of cerain independen variables. Since Execucomp daa begin in 1992, 1993 is he firs year of deb issue daa applicable. 9

10 measured as of he prior year-end (see secion 3.3). 6 The final sample includes 598 new deb issues by 274 disinc firms. 3.2 DEPENDENT VARIABLE: YIELD SPREADS ON NEW DEBT ISSUES To measure he cos of deb I use SPREAD, he spread (in basis poins) beween he yield o mauriy on he firm s firs deb issue of he year and he yield o mauriy on a U.S. Treasury bond of similar mauriy on he issuance dae. These daa are from he SDC Global New Issues daabase. Considerable research in his area also employs yield spread as he primary dependen variable (e.g. Bhojraj and Sengupa 2003; Klock e al 2005; Anderson e al 2004; Oriz-Molina 2006). Relaed research suggess alernaive measures of he cos of deb, including yield o mauriy (Khurana and Raman 2003), realized ineres cos (Sengupa 1998; Francis, LaFond, Olsson, and Schipper 2005), and he credi raing on he new deb issue (Shi 2003, Sengupa 1998). In comparison o yield spreads, yield o mauriy is no adjused for general economic condiions, realized ineres coss are noisy (Piman and Forin 2004) and include he effec of borrowings oher han jus he new issue, and he disconinuous naure of credi raings resuls in a cruder pariion of credi risk across borrowers (Wilson and Fabozzi 1990). Neverheless, hese alernaive measures of cos of deb are employed in sensiiviy analyses. 7 6 Some firms have more han one deb issue during a year. Sensiiviy ess using eiher a weighed-average yield spread across all of a firm s deb issues during a year or he larges (dollars of proceeds) issue of he year yield resuls similar o hose repored in he paper. 7 Some research uses he firm s overall credi raing, raher han he credi raing on he new issue (e.g. Ashbaugh-Skaife e al 2006). I do no sudy his measure as evidence in Holhausen and Lefwich (1986) suggess hese credi raings are subjec o rigorous analysis only a he ime of a new issue or around special evens; hus, hese raings end o be sicky. Furher, firm-level credi raings are less likely o reflec issue-specific feaures, like covenans, ha proec deb invesors. 10

11 3.3 CEO INCENTIVE VARIABLES Number of CEO Opions and Shares Held Sandard and Poor s Execucomp is used o obain daa on he number of CEO opions and shares held. OPT (STK) is he number of opions (common shares) held by he CEO, deflaed by he number of common shares ousanding (Oriz-Molina 2006). While OPT capures he level of CEO opion usage, i does no capure cross-secional variaion in key aspecs of hose opions, e.g., ime o mauriy, volailiy, and exercise prices. Furher, OPT does no disinguish beween newly graned and previously graned opions. Thus, alhough OPT is predicably posiively correlaed wih opion sensiiviies, i likely does no exploi all he variaion in CEO incenives ha use of he separae sensiiviies does. Imporanly, relaed research (Bille e al 2006; Knopf e al 2002) sugges ignoring he separae sensiiviies can lead o misleading inferences. The nex secion discusses he mehod o incorporae hese feaures of CEO opion porfolios Price and Volailiy Sensiiviy of CEO Opion and Share Porfolios Following relaed research I define CEO incenives as he sensiiviy of he CEO s porfolio of opions and sock o small changes in sock price and sock price volailiy. This proceeds in wo sages: Firs, I use he Core-Guay (2002) approach o esimae he sensiiviy of CEO opions o small changes in sock price and volailiy. Then, I follow Rajgopal and Shevlin (2002), Coles e al (2006) and ohers in measuring he sensiiviy of he value of CEO shareholdings o small changes in sock price and volailiy. The sums of he individual opion and share sensiiviies o reurn volailiy and share price form he key independen variables in his sudy. Their compuaion is discussed in deail nex. 11

12 Core and Guay (2002) esimae opion porfolio values and sensiiviies o sock price and sock reurn volailiy using one year of proxy saemen daa and some reasonable assumpions abou inpus for previous opion grans. Core and Guay (2002) show ha heir one-year approximaion mehod explains abou 99 percen of he variaion in opion porfolio values and sensiiviies ha one would obain from having full proxy saemen informaion on previously graned opions. The Core and Guay (2002) mehod requires opion daa o be pariioned ino opion grans made in he curren year and previously graned opions. For curren year grans, Execucomp provides he number of opions graned, opion exercise price, and he ime o mauriy. These values, along wih he firm s expeced dividend yield, he firm s expeced sock reurn volailiy, and he risk-free ineres rae for ha year, all from Execucomp, are used o esimae opion values and sensiiviies from he formulas in Appendix A. Execucomp does no provide complee daa on previously graned opions, hus he Core-Guay (2002) mehod makes assumpions on hese opions exercise prices and imes o mauriy o esimae heir values and sensiiviies. To esimae average exercise prices of previously graned opions I use he realizable values (excess of sock price over exercise price) for he firm s unexercisable and exercisable opions, from Execucomp. These amouns are measured a year-end, hus I deduc he number and fiscal-year end values of currenly graned opions (see above) in his compuaion. I hen divide he realizable values of he unexercisable and exercisable opions by he number of unexercisable and exercisable opions o obain an esimae of how far (per share) hese opions are in he money. Subracing his from he firm s end of year sock price 12

13 yields an esimae of he average exercise price on he unexercisable and exercisable opions. I also follow Core and Guay (2002) in esimaing he remaining ime o mauriy of ousanding opions. Since opions ypically include vesing provisions, exercisable opions likely have shorer imes o mauriy han unexercisable opions. If a firm grans opions in he curren year, hen he ime o mauriy of previously graned unexercisable (exercisable) opions is se o he ime o mauriy of he curren opion gran minus one (hree) years. If no opion grans are made in he curren year, he ime o mauriy of previously graned unexercisable (exercisable) opions is se o nine (six) years, as opions ypically are graned wih en years o mauriy. Following relaed research, he price and sock reurn volailiies of each ype of opion gran (curren year opion grans, previously graned unexercisable opions, and previously graned exercisable opions) are muliplied by he number of shares of each ype of gran, and hen summed. Then, like Coles e al (2006), Rajgopal and Shevlin (2002), Knopf e al (2002) and ohers, I add he sensiiviy of CEO shareholdings from a 1 percen change in sock price (compued as 1 percen imes he oal year-end dollar value of CEO shares and resriced sock held) o he sensiiviy of CEO opions o share price. 8 The resuling variables, labeled PRICESEN and VOLSEN, measure he sensiiviy of CEO sock and opion porfolios (in $housands) resuling from one percen changes in he firm s sock price and sock reurn volailiy, respecively. 3.4 CONTROL VARIABLES 8 Guay (1999) provides a mehod of measuring he impac of small changes in sock price volailiy on he value of CEO shareholdings. His resuls sugges his effec is immaerial, and like oher sudies I do no include an esimae of he effec of volailiy on CEO shareholdings in my measure of vega. 13

14 A long line of research suggess he need o conrol for feaures of he deb issuer, and characerisics of he deb issue iself, in sudying deerminans of yield spreads. Relaively more recen research (e.g. Bhojraj and Sengupa 2003; Ashbaugh-Skaife 2006) sugges corporae governance mechanisms are also relaed o eiher yield spreads or credi raings. Some of hese governance variables migh impac CEO incenives, necessiaing governance conrols. Thus, he regression analyses include a hos of conrol variables, discussed nex Corporae governance feaures As CEO compensaion migh be impaced by CEO power and board of direcors independence, I include an indicaor variable CEO which equals 1 if he CEO is also he chairman of he board, and oherwise zero, and INDEP, he percenage of he direcors ha are independen (no officers or direcors of he firm). CEO is measured wih Execucomp daa, and INDEP is measured using CDA/Specrum daa. Following Bhojraj and Sengupa (2003) and Ashbaugh-Skaife e al (2006) I include he percenage of shares held by insiuional invesors (INST) and a measure of concenraed ownership, defined as he percenage of ousanding shares held by he op larges insiuional invesors (TOP5). 9 Research also suggess accouning qualiy impacs he cos of deb (e.g. Sengupa 1998; Francis e al 2005; Ashbaugh-Skaife 2006). I include wo measures of accouning qualiy. The firs is a measure of working capial accruals qualiy (AQ) based on Dechow and Dichev (2002). Calculaion of his variable begins wih cross-secional esimaion, 9 Resuls are similar if concenraed ownership is defined insead as he percenage of ousanding shares owned by blockholders holding a leas 5 percen of he firm s ousanding shares. 14

15 by year and wihin 2-digi SIC code for all groups wih a leas 30 observaions, of he model: WCA 0 1CFO 2CFOi, 3CFOi,, (1) where WCA is working capial accruals in year, and CFO is ne operaing cash flows (Compusa #308) in eiher year -1,, or +1, and all variables are scaled by average oal asses (Compusa #6). Working capial accruals is compued as he change in curren asses (Compusa #4), minus he change in curren liabiliies (Compusa #5), minus he change in cash (Compusa #1), plus he change in deb in curren liabiliies (Compusa #34). The sandard deviaion of he residuals from hese indusry-year regressions over he pas five years, muliplied by negaive one, is he measure of working capial accruals qualiy (AQ) in he curren year. Larger values of AQ imply a beer mapping beween working capial accruals and cash flows, and hus higher qualiy working capial accruals. AQ is hus prediced o be inversely relaed o yield spreads. A second measure of accouning qualiy, based on Gu (2002) and employed in Ashbaugh-Skaife e al (2006) is also used. This measure is labeled TRANSP, and i is a measure of financial ransparency based on he imeliness of accouning earnings in explaining conemporaneous sock reurns. More precisely, his measure is derived from he following regression model: RET 0 1NIBEi, 2LOSSi, 3LOSSi, * NIBEi, 4 NIBE, (2) where RET is firm i s marke-adjused sock reurn over fiscal year, compued from he CRSP monhly reurn file; NIBE is firm i s year ne income before exraordinary iems (Compusa #18), scaled by firm i s marke value of equiy a he beginning of year (Compusa #25 * Compusa #199); LOSS is an indicaor variable which equals 1 if 15

16 NIBE is negaive, oherwise zero; and NIBE is firm i s change in ne income before exraordinary iems from year -1 o year, scaled by firm i s beginning of year marke value of equiy. The loss ineracion erm allows for differenial marke reacion o profis and losses, based on Hayn (2002). These regressions are esimaed crosssecionally, wihin 2-digi SIC and year groups having a leas 30 observaions. The (squared) residuals from equaion (2) reflec he degree of sock reurn no explained by conemporaneous earnings. Higher squared residuals imply less imely earnings (Gu 2002). As wih he accruals qualiy variable, I muliply he squared residuals from equaion (2) by negaive one. Thus, larger values of TRANSP indicae more imely earnings, which should correspond o lower yield spreads Issue characerisics Deb premiums are relaed o proxies for he firm s defaul risk (Fisher 1959). To conrol for defaul risk I include he Sandard and Poor s deb raing on he new issue, from SDC. For his sample S&P deb raings vary from AAA o B-, and I creae he ordinal variable RATING, which ranges from 1 o 16, as oulined in Appendix B. Research also shows ha deb premiums are relaed o oher characerisics of he deb issue. Thus I also include he size of he deb issue (SIZE), he number of years o mauriy (MATURITY), and he years o he firs call divided by he years o mauriy (CALL). The longer he ime o mauriy and he sooner he deb can be called by he issuer, he more ineres rae risk exposure o debholders. Thus, SPREAD is prediced o be posiively (inversely) relaed o MATURITY (CALL). The size of he deb issue migh proxy for greaer markeabiliy of he deb, implying lower risk premium, or alernaively 16

17 a higher deb burden and higher risk premium (Shi 2003). Thus, no direcional predicion is made for SIZE. Daa o compue hese variables are from SDC Issuer characerisics Following relaed research (e.g., Sengupa 1998, Shi 2003; Oriz-Molina 2006), I add issuer conrols, including firm size, measured as oal asses (ASSET); he raio of oal long erm-deb o oal asses (DEBT); he imes ineres earned raio (TIMES), equal o income before ineres expense divided by ineres expense; and profiabiliy (EBITDA), measured as earnings before ineres, axes, depreciaion, and amorizaion, scaled by oal asses, o conrol for defaul risk. Larger, more profiable firms are expeced o have lower defaul risk, suggesing SPREAD should be inversely relaed o ASSET, EBITDA, and TIMES. In conras, greaer leverage implies greaer risk of defaul, suggesing SPREAD should be posiively relaed o DEBT. Daa o compue hese measures are obained from Compusa (annual daa iems 6, 9, 14, 15, 16, and 18). To capure general economic condiions ha migh impac yield spreads I include MKT_RATE, he ineres rae on a 10-year U.S. Treasury bond issued in he same monh and year as he firm s issuance, obained from he Federal Reserve Economic Daabase. Evidence in Guay (1999) shows ha he sensiiviy of CEO wealh o sock reurn volailiy is relaed o heir firm s invesmen opporuniies. Following Guay (1999) I include he facor score (INV_OPP) from a common facor analysis ha uses research and developmen expendiures (Compusa #46) divided by marke value of asses, he book-o-marke raio (Compusa #60 / Compusa #25 * Compusa # 199), and oal capial expendiures plus acquisiions (Compusa # 30 + Compusa # 129 divided by 10 Some sudies conrol for he presence of subordinaed deb. Less han 3 percen of he deb issuances in his sudy are for subordinaed deb. Including an indicaor variable for subordinaed deb does no qualiaively impac his sudy s inferences. 17

18 marke value of asses. 11 Missing values of research and developmen, capial expendiures, and acquisiions are se o zero. A posiive relaion beween SPREAD and INV_OPP is prediced. Finally, Sengupa (1998) shows ha deb yield spreads are also relaed o sock reurn volailiy and firm performance, hus I include STDRET, he sandard deviaion of monhly sock reurns, and RET, cumulaive annual sock reurn, boh from CRSP, as addiional conrols. 3.5 DESCRIPTIVE STATISTICS ON CEO INCENTIVE COMPENSATION VARIABLES Panel A of Table 1 presens descripive informaion on he CEO incenive and yield spread variables. Sample CEO s on average (median) hold opions (shares) oaling abou (0.325) percen of heir firm s ousanding shares (i.e., less han one percen in oal). Median values of PRICESEN and VOLSEN ($housands), a and respecively, are comparable o hose in relaed research. For example, median values for hese variables are and in Knopf e al (2002) and 206 and 34 in Coles e al (2006), respecively. 12 The median yield spread is 110 basis poins. 13 Panel B of Table 1 presens Pearson correlaions beween he CEO incenive and ownership variables and he yield spread on he new deb issue. As expeced, OPT is posiively correlaed wih boh PRICESEN ( = 0.329) and VOLSEN ( = 0.258). Furher, while PRICESEN and VOLSEN are also posiively correlaed wih one anoher ( = 0.656), he correlaions across OPT, PRICESEN, and VOLSEN are far from one, 11 Marke value of asses is defined as he book value of deb (Compusa # 6 Compusa # 60) plus he marke value of equiy. 12 Sudying a broad cross-secion of indusries, Core and Guay (2002) repor a median of $28 million for opion sensiiviy o reurn volailiy. 13 Shi (2003), Bhojraj and Sengupa (2003), Anderson e al (2004), and Klock e al (2005) repor median yield spreads of 78, 93, 103, and 143 respecively. 18

19 suggesing hese measures capure, a leas o some exen, differen feaures of CEO incenives. Consisen wih expecaions, SPREAD is posiively correlaed wih he number of CEO opions ( = 0.327) and shares held ( = 0.140), and inversely relaed o he sensiiviy of CEO opions o share price ( = ). The correlaion beween SPREAD and he sensiiviy of CEO opions o price volailiy, while unexpecedly negaive, is modes ( = ). 3.6 DESCRIPTIVE STATISTICS ON DEBT ISSUE AND ISSUER CHARACTERISTICS Table 2 presens descripive saisics on he deb issue (Panel A) and issuer characerisics (Panel B). From Panel A of Table 2, he median deb issue is for $248 million, is raed A- by Sandard and Poor s (median value of 7 for RATING), maures in 10 years, and he firs call is on average abou 5 years from he dae of issuance (mean value of 0.47 for CALL). Panel B of Table 2 presens descripives on issuer characerisics. The median firm has abou $7.90 billion of oal asses, a deb-asses (DEBT) raio of 24.1 percen, EBITDA of 14.0 percen of oal asses, and a imes-ineres earned raio above 3.5. Values for INV_OPP, a measure of invesmen opporuniies from a common facor analysis, exhibi considerable variaion, as shown by he 1 s (3 rd ) quarile value of (0.529). The sandard deviaion of monhly sock reurns has a mean (median) of (0.084), and MKT_RATE averages 5.18 percen. Descripive saisics for he governance variables are also comparable o prior research. Insiuional owners hold on average (median) abou percen of he sample firms ousanding shares, and he larges five insiuional owners hold a median 19

20 of percen of ousanding shares. The ypical board has abou 80 percen independen members, and he CEO is chairman of he board for percen of he sample observaions. Boh measures of accouning qualiy exhibi considerable variaion. For insance, TRANSP averages , and has a 1 s (3 rd ) quarile value of ( ). Similarly, AQ averages , and has 1 s (3 rd ) quarile values of (-0.017). 3.7 CREDIT RATINGS AND CEO INCENTIVES Evidence suggess ha credi raing agencies consider CEO ownership and opions when raing deb. For example, Sandard and Poor s (2004) noes ha ownership srucure and usage of sock opions is one of he key componens of is Corporae Governance Score, while Moody s (2003) noes ha execuive pay arrangemens ha provide large shor-erm incenives paricularly hose relaed o equiy valuaions, may pose excessive risk, paricularly from a credi sandpoin. Empirical research also suggess ha CEO ownership impacs credi raings (e.g., Oriz-Molina 2006). Thus, RATING likely capures some of he variaion in he CEO incenive variables of ineres in his sudy. I herefore follow relaed research and use RES_RATING, he residual from OLS esimaion of a regression of he credi raing on he new deb issue on CEO opion and share ownership, and he CEO dela and vega variables. 14 Thus, RES_RATING is he informaion in a firm s new issuance deb raing no explained by he CEO incenives of ineres in his sudy. The adjused-r 2 of suggess hese variables have nonrivial explanaory power for credi raings on new issues Empirical Models 14 Oriz-Molina (2006), Anderson e al (2003), and Klock e al (2005) follow a similar approach. 15 The (unabulaed) esimaed equaion is RATING = *OPT *STK *LPRICESEN 0.210*LVOLSEN. The coefficiens on OPT, STK, and LPRICESEN are significan a p<0.01. The coefficien on LVOLSEN is no significan a convenional levels (p=0.14). 20

21 4.1 PRIMARY REGRESSION MODEL In addiion o he independen variables discussed above, he regression model includes indusry dummies (IND), corresponding o SIC codes 0-999, ,, , and year (YR) dummies. 16 All CEO share, opion, and sensiiviy variables are measured as of he las fiscal year-end (i.e. year -1) before he deb issuance. All issuer characerisics are also measured as of year -1 relaive o he deb issue. Indusry (j) and year (y) dummies perain o year, he year of deb issue. Thus, he empirical model is: SPREAD 0 1OPT 16 5RES_ RATING 9LASSET 13INV _ OPP INST 20TRANSP 2STK 10 17TOP5 21 6DEBT LSIZE AQ 14STDRET 3LPRICESEN 18INDEP 22 RET 7EBITDA 11LMATURITY 15MKT _ RATE 19CEO 8 0IND j 1 4LVOLSEN 8TIMES 12CALL 11 y 1 0YR. (3) Variables are as defined above, wih he excepion of LPRICESEN, LVOLSEN, LASSET, LSIZE, and LMATURITY, which, due o skewness in heir disribuions and consisen wih relaed research, are he naural logarihms of PRICESEN, VOLSEN, ASSET, SIZE, and MATURITY, respecively. To miigae poenial economeric concerns due o auocorrelaion or heeroscedasiciy I use Huber-Whie robus sandard errors in compuing -saisics (Huber 1967; Whie 1980). These sandard errors employ a byfirm cluser ha assumes observaions are independen across firms bu no necessarily independen wihin firms. 5. Empirical Resuls 5.1 PRIMARY REGRESSION RESULTS 16 SIC codes 9000 and above and year 2004 are capured in he inercep. 21

22 Resuls of OLS esimaion of equaion (3) appears in he Specificaion 1 column of Table As expeced, lower-raed deb (RES_RATING) receives higher yield spreads ( 5 = , p<0.01). 18 In addiion, more highly leveraged firms, wih more volaile sock reurns, also receive higher yield spreads, as shown by he coefficiens on DEBT ( 6 = , p<0.10) and STDRET ( 14 = , p<0.01). Longer imes o mauriy and larger deb issues are also associaed wih higher yield spreads ( 11 = , p<0.01; 10 = 4.690, p<0.10). Larger, beer-performing firms receive lower yield spreads, as evidenced by he coefficiens on LASSET ( 9 = , p<0.10) and RET ( 22 = , p<0.05). Yield spreads are also relaed o all bu one of he corporae governance variables. In paricular, yield spreads are lower for firms wih a greaer percenage of shares held by insiuions ( 16 = , p<0.05), firms wih more imely earnings ( 20 = , p<0.05), beer working capial accruals qualiy ( 21 = , p<0.05), and firms wih heir CEO as chairman of he board ( 19 = , p<0.05). Finally, yield spreads are higher for firms wih higher levels of concenraed insiuional ownership (TOP5), as 17 equals 0.644, significan a p<0.10. In addiion, higher levels of CEO opion ( 1 = ) and share ownership ( = 1.251) are relaed o higher yield spreads, and hese relaions are significan a p<0.01 and p<0.05, respecively. These resuls are consisen wih hose in Oriz-Molina (2006). More imporanly, afer conrolling for he number of CEO shares and opions held, he 17 Coefficiens on he indusry (IND) and year (YR) indicaor variables are no abulaed for breviy. p- values repored in he paper are for one-ailed ess where coefficien signs are prediced, and oherwise wo-ailed ess. 18 Resuls of unabulaed regressions sugges credi raings explain a large porion of he variaion in yield spreads, hus usurping some of he poenial explanaory power of he oher conrol variables. 22

23 sensiiviy of CEO opion and share porfolios o share price emerges as a significan explanaor of yield spreads. Specifically, he coefficien on LPRICESEN is negaive ( 3 = ) and significan a p<0.01. Finally, he resuls sugges no relaion beween yield spread and CEO vega. The resuls are consisen wih his sudy s firs hypohesis he cos of deb is inversely relaed o he sensiiviy of CEO porfolios o share price. Lile suppor is found for his sudy s second hypohesis he resuls insead sugges he cos of deb bears lile relaion o he sensiiviy of CEO porfolios o sock reurn volailiy. In he presence of CEO ownership and oher conrol variables, he sensiiviy of CEO wealh o sock price, bu no reurn volailiy, helps explain yield spreads on new deb issues. To provide informaion on he economic significance of he resuls, I compare a firm a he median level of each of OPT, STK, LPRICESEN, and LVOLSEN wih a firm a he 3 rd quarile level of each of hese variables. The CEO of a sample firm a he 3 rd quarile of hese variables has a value of OPT of ( ) higher han he CEO of a sample firm a he median level of OPT. This generaes an esimaed 11 basis poin increase (0.511 x ) in yield spread for a firm a he 3 rd quarile of OPT compared o a firm a he 2 nd quarile level of OPT. Compued similarly, a firm a he 3 rd quarile of STK would expec abou a 1.10 basis poin higher yield spread, compared o a firm a he 2 nd quarile level of STK. These effecs are consisen wih hose repored in Oriz-Molina (2006). Since dela and vega are logged, heir regression coefficiens measure how a onepercen change in LPRICESEN (or LVOLSEN) impacs SPREAD, in unis of regression coefficien/100 (Wooldridge 2000). For insance, a one percen increase in LPRICESEN 23

24 is relaed o an esimaed (compued as /100) basis poin decrease in SPREAD. A sample firm a he 3 rd quarile level of OPT has a ($000s) higher level of PRICESEN ( , from Panel A of Table 1) relaive o a firm a he 2 nd quarile level of PRICESEN. This roughly 208% percen higher value of PRICESEN ranslaes ino roughly a 35 basis poin reducion in SPREAD for a sample firm a he 3 rd quarile level of PRICESEN, relaive o a sample firm a PRICESEN s 2 nd quarile value. Compued similarly, a sample firm a he 3 rd quarile level of VOLSEN would expec abou a 3 basis poin smaller yield spread han would a firm a he 2 nd quarile level of VOLSEN. Combining hese esimaed economic effecs ogeher reveals ha, in sum, higher levels of he CEO incenive variables employed in his sudy are associaed wih lower coss of deb on new issues. The ne benefi from moving from he 2 nd quarile values for each of he CEO incenive variables o he 3 rd quarile values for such variables is abou a 26 basis poin reducion ( ) in he yield spread on a new deb issue. This is comparable o evidence in Anderson e al (2003, deb coss are abou 32 basis poins lower in firms wih founding family ownership han in firms wihou founding family ownership), and Klock e al (2005, deb coss are abou 30 basis poins lower for firms wih high aniakeover provisions versus firms wih low aniakeover provisions). 5.2 WU-HAUSMAN TESTS FOR ENDOGENEITY AND 2SLS RESULTS The analyses hus far rea CEO ownership and wealh sensiiviies as exogenous. I is possible however he CEO compensaion variables are endogenous. This endogeneiy migh arise if an omied variable correlaed wih CEO incenives and yield 24

25 spreads drives his sudy s resuls, or if he cos of deb impacs how firms esablish heir CEO opion incenive conracs. 19 The use of year -1 opion variables o explain yield spreads on year deb issues helps alleviae concerns wih endogeneiy. In addiion, he opion sensiiviy variables employ daa from several years before he deb issuance, making i even less likely ha opion vega and dela are deermined simulaneously wih yield spreads. Bhaga and Jefferis (2002) however argue ha corporae performance, capial srucure, and corporae ownership are inerrelaed, and mos sudies ha examine a managerial choice variable as a predicor confron endogeneiy concerns (Larcker 2003). I es wheher eiher CEO opion holdings, share ownership, or CEO sensiiviies are endogenous by employing a es suggesed by Wu (1973) and Hausman (1978). This es employs a wosage, insrumenal variables approach, discussed nex. Specifying an appropriae se of insrumenal variables for OPT, LPRICESEN, LVOLSEN, and STK is nonrivial. I use insrumens suggesed by Himmelberg, Hubbard, and Palia (1999), Knopf e al (2002), and Oriz-Molina (2006). In addiion o he exogenous variables from equaion (3), hese insrumens include he naural logarihm of sales; gross propery, plan, and equipmen, scaled by oal asses; research and developmen expenses divided by sales; adverising expenses divided by sales; cos of goods sold divided by sales; sales per employee; selling, general, and adminisraive expenses divided by sales; he change in sales; sandard deviaion of monhly sock reurns; capial expendiures; operaing income; he CEO s cash compensaion (bonus plus salary), as a percenage of oal compensaion; and squared erms of each of hese 19 Oriz-Molina (2007) finds ha he relaion beween he change in CEO wealh and curren sock reurn decreases in sraigh-deb leverage, and increases wih converible-deb leverage. This suggess CEO payperformance sensiiviy is relaed o capial srucure. 25

26 addiional variables. Missing values of research and developmen expenses and adverising expenses are se o zero, and dummy variables ha equal 1 when research and developmen or adverising are non-missing, and zero oherwise, are also included as insrumens. Wih he excepion of CEO cash compensaion, obained from Execucomp, daa for hese addiional variables are from Compusa. In he firs-sage regressions, OPT, STK, LPRICESEN, and LVOLSEN are each separaely regressed on he insrumenal variables above and he exogenous variables from equaion (3). The prediced values from each of hese separae firs-sage OLS regressions are hen added as independen variables in an OLS esimaion of equaion (3). The Wu-Hausman es suggess an independen variable is endogenous if he coefficien on is prediced value in he second-sage regression is saisically differen from zero. The resuls of he (unabulaed) firs sage regressions sugges he insrumens explain a nonrivial amoun of he cross-secional variaion in he CEO variables. The adjused-r 2 s from he separae OPT, STK, LPRICESEN, and LVOLSEN firs-sage regressions are 41.76, 28.71, 50.33, and respecively. According o he Wu- Hausman es, he resuls in he second sage regression sugges lile evidence ha any of OPT, STK, LPRICESEN, and LVOLSEN are endogenous; none of he coefficiens on he firs-sage prediced values for hese variables has a -saisic even above 1 (in absolue value) in he second sage. 20 Resuls of he Wu-Hausman es nowihsanding, I nex esimae a wo-sage leas squares (2SLS) regression in which OPT, STK, LPRICESEN, and LVOLSEN are considered endogenous. The second-sage resuls from esimaing equaion (3), using 20 The coefficiens on OPT, STK, and LPRICESEN in he second sage regression are comparable in magniude and saisical significance o hose repored in column 1 of Table 3. 26

27 wo-sage leas squares and he insrumenal variables above, are presened in he Specificaion 2 column of Table 3. Resuls on conrol variables are quie similar o hose repored using OLS. In addiion, he coefficien on OPT is posiive ( 1 = ) and significan a p<0.05, while he coefficien on LPRICESEN is negaive ( 3 = ), and significan a p<0.01. The coefficiens on CEO share ownership and sensiiviy o reurn volailiy are no differen from zero. 5.3 OLS RESULTS USING CHANGES Anoher sandard echnique o address endogeneiy is o employ a changes model (e.g. Klock e al 2005; Anderson e al 2004). I compue percenage changes in each of he variables in equaion (3), and esimae an OLS regression of he percenage change in yield spread on percenage changes in CEO incenives and conrol variables. These ess are limied o firms ha issue deb in consecuive years, hus sample size and he power of he ess is reduced. Neverheless, he resuls, repored in he Specificaion 3 column in Table 3 are consisen wih hose repored earlier. Changes in yield spreads are posiively relaed o changes in CEO opion ownership ( 1 = 0.310) and inversely relaed o changes in he sensiiviy of CEO opion porfolios o share price ( 3 = ), and boh relaions are significan a beer han he 0.05 level. In sum, he evidence in secions 5.2 and 5.3 miigae he likelihood his sudy s resuls are driven by endogeneiy. Resuls of furher aemps o address endogeneiy are repored in secion ALTERNATIVE COST OF DEBT MEASURES Prior research suggess yield o mauriy (Khurana and Raman 2003), oal ineres cos (Piman and Forin 2004; Francis e al 2005), and credi raings on new deb issues (Shi 2003, Sengupa 1998) as alernaive measures of he cos of deb. I es he 27

28 sensiiviy of he resuls o each of hese alernaive cos of deb measures. Yield o mauriy (YTM ) and he S&P raing on he new deb issue (Raing ) are colleced from SDC and ineres cos (In_Cos ) is oal ineres expense (Compusa #15) divided by oal long-erm borrowings (Compusa # s 9 plus 34). Consisen wih Francis e al (2005) and Piman and Forin (2004), ineres cos is winsorized a he 5 h and 95 h perceniles of is sample-wide disribuion. The model is, COST 0 1OPT 10LSIZE 19CEO 14STDRET 5RES_ RATING 2STK 6DEBT 20TRANSP 11LMATURITYi, 12CALL 15MKT _ RATE 3LPRICESEN 21AQ 7EBITDA 16INST 13INV _ OPP 22RET 4LVOLSEN 8TIMES 17TOP5 8 j 1 0IND 9LASSET 18INDEP 11 y 1 0YR where all variables are as defined as above and COST is eiher YTM, In_Cos or Raing. 21 Resuls are repored in Table 4. From he Specificaion 1 column of Table 4, yield o mauriy is posiively relaed o OPT ( = 0.226, p<0.01) and STK ( = 0.08, p<0.05), and inversely relaed o LPRICESEN ( = , p<0.01) These resuls corroborae evidence repored in Table 3; he cos of deb decreases (increases) wih he sensiiviy of CEO wealh o share price (4) (he number of opions and shares held by he CEO). The cos of deb bears no significan relaion wih CEO vega. Likewise, column 2 of Table 4 shows ha oal ineres cos is posiively relaed o OPT ( = 0.234, p<0.05) and inversely relaed o LPRICESEN ( = , p<0.01). Column 3 of Table 4 repors resuls of esimaing equaion (4) wih he Sandard and Poor s raing on he new deb issue as he dependen variable. Recall ha a higher 21 The residual credi raing variable (RES_RATING ) is excluded from he regression wih Raing as he dependen variable. 28

29 value for Raing indicaes a lower (worse) credi raing. The resuls sugges new deb raings are worse for firms wih higher levels of CEO opion and share ownership, as and are posiive (= and 0.028) and significan a p<0.01 and p<0.05 respecively. Resuls on LPRICESEN are consisen wih hose repored earlier, as is negaive (= ) and significan a p<0.05. While he abulaed resuls use OLS, qualiaively similar resuls are obained wih logisic regression. 5.5 Oher Tess Addiional Mehods o Address Endogeneiy In addiion o he ess discussed in Secions 5.2 and 5.3, several oher approaches were employed o address endogeneiy concerns. Firs, I excluded curren year opion grans in my compuaion of CEO dela and vega variables. This places measuremen of he key independen variables in his sudy a leas wo years in advance of he deb issuance. Resuls wih hese alernaive CEO incenive variables are comparable o hose repored in he paper. Second, Guay (1999) argues ha CEO s wih higher cash compensaion are more diversified and hus less risk-averse. Berger, Ofek, and Yermack (1997) argue ha CEO s wih longer enures and higher cash compensaion are more enrenched, and more risk-averse. The resuls of his sudy are unchanged when variables for CEO enure and cash compensaion (salary plus bonus), colleced from Execucomp, are included as independen variables. Third, he volailiy of sock reurns is an inpu in he Black-Scholes opion value used o compue he CEO sensiiviy variables. As noed by Guay (1999), i is hus possible ha a mechanical relaion beween sock price volailiy and he CEO wealh 29

30 sensiiviy variables influence he regression coefficiens. Following Guay (1999) I recompued CEO dela and vega by using he mean sock price volailiy, by year, for he enire Execucomp populaion wih daa, insead firm-specific measures of sock price volailiy. Once again he resuls are qualiaively similar o hose abulaed Alernaive Conrol Variables Qualiaively similar resuls are obained when esimaing he regressions wih he naural logarihm of marke value of equiy insead of oal asses, alernaive measures of firm performance (sales margin and reurn on asses), and afer replacing he facor score for invesmen opporuniies wih is hree separae componens. Similar resuls are also obained when adding an indicaor variable for loss years and including he book-marke raio. Some sudies (e.g. Klock e al 2005) use a governance index developed by Gompers e al (2003). Including his variable reduces sample size bu does no impac he resuls Regression Diagnosics Variance inflaion facors for cerain of he indusry dummy variables in cerain regressions approach 30, a hreshold beyond which Belsley, Kuh, and Welsch (1980) deem mulicollineariy o be a concern. Qualiaively similar resuls o hose repored in he paper are obained afer dropping he indusry dummy variables. The highes variance inflaion facor on variables oher han he indusry dummies is 6.24; he variance inflaion facors on OPT, STK, LPRICESEN, and LVOLSEN for he regression repored in column 2 of Table 3 are 2.47, 1.75, 3.53, and 3.82 respecively, suggesing lile impac of mulicollineariy from hese independen variables. Similar resuls o 30