Friday, July 30, 2004

Leverage decision and manager compensation with choice of effort and volatility

Leverage decision and manager compensation with choice of effort and volatility

Cadenillasa, Cvitani and Zapatero (CCZ) in an upcoming Journal of Financial Economics (JFE) paper, model the incentive effects of paying executives with either levered, or unlevered, equity.

Their model, which is probably too complex to use in most undergraduate classes, separates managers based on ability level. The authors conclude that “levered stock seems to be the optimal compensation for high-type managers, while unlevered stock is optimal for low-type managers.

The intuition is that the risk-neutral shareholders would like the manager to take more aggressive actions than the manager would otherwise prefer. Levered stock provides the correct incentives to good managers, as they will be more willing to take greater risk because their higher ability will enable them to correct a possible bad state through more effort.

However, low-type managers will be reluctant to accept the risk that comes with the extra (increase in) leverage, as they are more averse to the possibility that the value of the firm drops rapidly in price. For low-type managers, it follows that unlevered stock will be the preferable type of compensation.” (paragraph breaks inserted).

Additionally the model shows that levered equity grants are less favorable for risky firms, firms with little positive momentum, and smaller firms.

Even though the authors are careful to point out that the paper is dealing with the optimal grant of levered or unlevered shares, and hence a compensation paper, it may well have ramifications on capital structure as well. For instance, if we allow other things to remain constant it could be argued that firms with better management should have higher levels of leverage. Interesting!

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