How Executive Compensation Affects Firms’ Choice of Financing

The separation of corporate ownership from control leads to an agency problem caused by the divergent interests of shareholders (the principals) and management (the agent).  One area of contention is the level of risk-taking by the firm.  Managers’ investment in human capital makes them more risk-averse than shareholders are, and this difference creates losses that account in part for the agency cost of equity.  To mitigate this cost, prior research suggests that managers be paid in stock and stock options, in addition to cash compensation, so that their interests are aligned with those of shareholders.

Unfortunately, the convergence of managers’ … Read more