What ceo can do with high cost of capital

Jensen and Meckling (1976) illustrate that, to reduce agency conflicts with managers, shareholders are expected to tie managers’ wealth to firm, or stock-price, performance. By using compensation policy to manage the slope of the relation between managers’ wealth and stock price, shareholders can induce managers to take actions that increase equity value. Managing this slope, however, is not sufficient to control agency conflicts arising between stockholders and managers. As is well-recognized in studies by Jensen and Meckling (1976), Haugen and Senbet (1981), and Smith and Stulz (1985), the convexity of the relation between stock price and managers’ wealth, in addition to the slope, must be managed to induce managers to make optimal investment and financing decisions.

The convexity, or curvature, of the wealth–performance relation refers to the sensitivity of managers’ wealth to the volatility of equity value. To date, no empirical evidence exists on the importance of convexity in the design of executives’ incentives. This study quantifies the impact of equity risk, or stock-return volatility, on the value of stock options and common stock held by corporate CEOs, and provides evidence on cross-sectional determinants of convexity in executives’ incentive schemes.

Smith and Stulz (1985) show that when managers’ wealth is dependent upon firm performance, risk-aversion can cause managers to pass up risk-increasing, positive net-present-value projects. They illustrate how shareholders can reduce this risk-related agency problem by using stock options or common stock to structure managers’ wealth as a convex function of firm performance. Since risk-related investment problems are expected to be greatest for firms with substantial investment opportunities, the magnitude of convexity in executives’ wealth–performance relation is predicted to be positively related to the proportion of assets that are growth options. Smith and Watts (1992) also hypothesize that growth options are a determinant of executives’ incentives. However, their argument focuses primarily on the slope of the wealth–performance relation. Theory suggests that, in addition to influencing the slope, the investment opportunity set is also a determinant of the convexity in the wealth–performance relation.

To illustrate differences between the slope and convexity of the wealth–performance relation, consider the options and common stock held by the following two CEOs. As of December 31, 1993, the CEO of Conrail Inc. held 94,400 shares of stock, worth $6.3 million, and 102,500 stock options, worth approximately $3.9 million. At that time, the CEO of GTE Corp. held 61,100 shares of stock worth $2.1 million and 539,900 stock options worth approximately $4.3 million. Using a Black and Scholes (1973) option-pricing framework (its application in this study is discussed in Section 4), and parameter values as of December 31, 1993, the securities held by each of the CEOs would increase in value by about $600,000 for a 5% increase in their firm's stock price. That is, the slope of the wealth–performance relation is approximately the same for both CEOs on this date. However, the convexity in their wealth–performance relation differs considerably. The GTE CEO's securities would increase in value by about $505,000 for a 5 percentage point increase in the annualized standard deviation of GTE's stock returns. This figure compares to a $55,000 increase in the value of the Conrail CEO's securities for the same increase in stock-return volatility. Therefore, the GTE CEO appears to have significantly greater risk-taking incentives than the CEO of Conrail Inc.

Using compensation data for 278 corporate CEOs, I present evidence that stock options, but not common stockholdings, play an economically significant role in increasing the convexity of the relation between managers’ wealth and stock price. I measure convexity as the change in the value of managers’ stock options and stockholdings for a given change in stock-return volatility. The median change in the value of CEOs’ option portfolios for a 10 percentage point change in the standard deviation of stock returns is approximately $300,000, with an interquartile range of $425,000.1 Convexity provided by common stock, on the other hand, is several orders of magnitude lower than that of stock options, and is of little economic importance for most CEOs in the sample. The median change in the value of CEOs’ common stockholdings for a 10 percentage point change in return volatility is only $22, with an interquartile range of $2400. Since most firms are financially healthy, common stock, when viewed as an option on the firm's asset value, is generally so deep 'in the money’ that the payoff to shareholders is effectively a linear function of firm value.

I also find that the convexity in CEOs’ incentive schemes is positively related to the proportion of a firm's assets that are growth options. Thus, firms appear to provide managers with incentives to invest in risky projects when the potential loss from forgoing valuable risk-increasing projects is greatest. Finally, equity risk is shown to be positively related to the convexity provided to CEOs, suggesting that managers’ investment and financing decisions are influenced by their risk-taking incentives.

Section 2 briefly highlights the relation between convexity, managers’ preferences toward firm risk, and risk-related agency costs. The data are summarized in Section 3. Section 4 describes the procedure used to estimate the slope and convexity of the wealth–performance relation, and provides descriptive findings. The cross-sectional relation between firms’ investment opportunities and the convexity provided to managers is explored in Section 5. Section 6 examines whether firms’ stock-return volatility is related to the convexity of managers’ wealth–performance relation. I conclude with Section 7.

• I find empirical evidence that financially distressed firms increase investment risk. I exploit a natural experiment where the treated firms must refinance long-term debt during the 2007–2008 credit crisis. When focusing on firms where the incentive to risk-shift is theoretically greater, such as financially vulnerable firms and those with better governance, I find the increase in investment risk is most prevalent among firms that are the most financially vulnerable and when executives benefit from increased risk. Contrary to previous empirical papers that did not find causal evidence of risk-shifting, these results suggest that the risk-shifting does occur when firms are financially distressed.

• We examine the impact of social capital at the US county level on managerial risk-taking incentives. We hypothesize that corporate executives in counties with higher social capital would accept lower equity-based compensation then faithfully behave in terms of efforts and risks following the shareholder trust or restrain themselves from rent-seeking which may harm shareholders. Our main test results with firm fixed effects are consistent with our hypothesis. Additional robustness checks—propensity score matching, instrumental variable, and difference-in-differences analyses—corroborate our main findings. Thus, it is highly likely that social capital has a curbing effect on executive risk-taking incentives.

• The tenets of agency theory suggest that CEO inside debt holdings induce risk-reducing corporate investments. Further, the coinsurance hypothesis implies that diversification strategies designed to decrease cross-segment correlations reduce firm risk. Motivated by these views, we hypothesize a positive relationship between CEO inside debt holdings and the risk-reducing (e.g., coinsurance) effect of diversification. Moreover, we examine the impact of coinsurance, induced by CEO inside debt holdings, on the excess value of diversification. Using a sample of 4053 firm-year observations for the period of 2006–2013, we document a positive relationship between CEO inside debt and the extent of the coinsurance effect of diversification. In addition, consistent with the implications of the managerial risk aversion hypothesis that risk-reducing corporate diversification strategies destroy shareholder value, our results show that the coinsurance effect of diversification, when induced by CEO inside debt, negatively affects the excess value of diversification.

• We study changes in the number of CEO stock option grants. Despite some evidence of short-term rigidity, the number of options granted changes frequently over time. CEOs of firms with unusual investment patterns subsequently receive fewer stock options as part of their compensation packages. CEOs who hold exercisable deeply-in-the-money options (overconfident CEOs) also receive fewer stock options in subsequent periods. Our results show that past CEO behavior predicts stock option grants. These insights can inform theoretical discussion on option-granting behavior and, more broadly, on the board's re-contracting process.

• Motivated by the internal governance theory, we investigate the links between subordinate executives' horizon and firm policies. Using the number of years to retirement to capture subordinate executives' horizon inside the firm, we find that subordinates' horizon is positively associated with firm's risk-taking, long-term investments growth, and research and development productivity, but negatively related to the dividend decision and the payout ratio. We also find a positive relationship between subordinates' horizon and firm value. Our results are robust to controlling for alternative explanations including the pay gap between CEO and subordinate executives, executives' overconfidence, CEO's decision horizon, and other governance mechanisms. The results are also robust to alternative measures of subordinates' horizon, and after addressing potential endogeneity concerns.

• Motivated by the limited evidence for a relationship between oil uncertainty and firms' risk-taking in China, we investigate how oil uncertainty (as proxied by the oil volatility risk premium) impacts firms' risk-taking and explain the mechanism. To highlight firms' expectations, growth opportunities, and ability to process new information, we use three proxies for firms' risk-taking (the implied cost of capital, the idiosyncratic volatility and the idiosyncratic skewness). Our empirical results show that oil uncertainty increases firms' risk-taking through the channel of risk compensation or real options related to firms' growth opportunities rather than risk-aversion. Oil uncertainty has a positive effect on firms' risk-taking proxied by the implied cost of capital and the idiosyncratic volatility but a negative effect on firms' risk-taking proxied by the idiosyncratic skewness related to contract options. Various variables involved in ownership, operating leverage and industrial conditions interact with oil uncertainty to affect firms' risk-taking through different channels. Our findings contribute to a greater understanding of the uncertainty in crude oil markets and firms' risk-taking behavior.

• We study the optimal composition of corporate boards. Directors can be either monitoring or advisory types. Monitoring constrains the empire-building tendency of chief executive officers (CEOs). If shareholders control the board nomination process, a non-monotonic relation ensues between agency problems and board composition. To preempt CEO entrenchment, shareholders may assemble an adviser-heavy board. If a powerful CEO influences the nomination process, this may result in a more monitor-heavy board. Regulations strengthening the monitoring role of boards can be harmful in precisely those cases in which agency problems are severe or in which CEO entrenchment is a threat to corporate governance.

• We extend the literature on how managerial traits relate to corporate choices by documenting that firms run by female CEOs have lower leverage, less volatile earnings, and a higher chance of survival than otherwise similar firms run by male CEOs. Additionally, transitions from male to female CEOs (or vice versa) are associated with economically and statistically significant reductions (increases) in corporate risk-taking. The results are robust to controlling for the endogenous matching between firms and CEOs using a variety of econometric techniques. We further document that this risk-avoidance behavior appears to lead to distortions in the capital allocation process. These results potentially have important macroeconomic implications for long-term economic growth.

• We provide empirical evidence on the positive effect of non-executive employee stock options on corporate innovation. The positive effect is more pronounced when employees are more important for innovation, when free-riding among employees is weaker, when options are granted broadly to most employees, when the average expiration period of options is longer, and when employee stock ownership is lower. Further analysis reveals that employee stock options foster innovation mainly through the risk-taking incentive, rather than the performance-based incentive created by stock options.

• Current research shows that firms are more likely to benchmark against peers that pay their Chief Executive Officers (CEOs) higher compensation, reflecting self serving behavior. We propose an alternative explanation: the choice of highly paid peers represents a reward for unobserved CEO talent. We test this hypothesis by decomposing the effect of peer selection into talent and self serving components. Consistent with our prediction, we find that the association between a firm's selection of highly paid peers and CEO pay mostly represents compensation for CEO talent.

• Classic financial agency theory recommends compensation through stock options rather than shares to counteract excessive risk aversion in agents. In a setting where any kind of risk taking is suboptimal for shareholders, we show that excessive risk taking may occur for one of two reasons: risk preferences or incentives. Even when compensated through restricted company stock, experimental CEOs take large amounts of excessive risk. This contradicts classical financial theory, but can be explained through risk preferences that are not uniform over the probability and outcome spaces, and in particular, risk seeking for small probability gains and large probability losses. Compensation through options further increases risk taking as expected. We show that this effect is driven mainly by the personal asset position of the experimental CEO, thus having deleterious effects on company performance.

• This paper examines the effect of risk-taking incentives on acquisition investments. We find that CEOs with risk-taking incentives are more likely to invest in acquisitions. Economically, an inter-quartile range increase in vega translates into an approximately 4.22% enhancement in acquisition investments, consistent with the theory that risk-taking incentives induce CEOs to undertake investments. Importantly, the positive relation between vega and acquisitions is confined only to non-overconfident CEO subgroup. Further, corporate governance does not generally affect the association between vega and acquisition investments. Finally, vega is positively related to bidder announcement returns.