Gerald T. Garvey and Amin Mawani
The purpose of this study is to present theory and empirical evidence on whether changes in leverage are systematically associated with changes in the CEO's risk incentives over…
Abstract
Purpose
The purpose of this study is to present theory and empirical evidence on whether changes in leverage are systematically associated with changes in the CEO's risk incentives over time.Design/methodology/approach – A model is developed to explain the dynamic relationship between leverage and managers’ risk incentives, and empirically tested with data on executive stock option grants. The model relies on the observation that the risk sensitivity of a call option does not monotonically increase or decrease in the value of the underlying stock.Findings – It is found that changes in the CEO's risk incentives are not systematically correlated with changes in the firm's leverage over time.Research limitations/implications – The near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage, and therefore executives’ incentives to take equity risk are not correlated with firm leverage.Practical implications – For reasonable parameter values, this risk incentive‐maximizing stock price lies very close to the option's exercise price. This finding provides evidence that stock options plans granted approximately at‐the‐money encourage maximum risk‐taking by managers in a dynamic setting.Originality/value – This paper develops theory and evidence to explain why executive stock options are usually granted at‐the‐money.
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Nalinaksha Bhattacharyya, Amin Mawani and Cameron K.J. Morrill
This paper seeks to present and test a model of the association between dividend payout and executive compensation.
Abstract
Purpose
This paper seeks to present and test a model of the association between dividend payout and executive compensation.
Design/methodology/approach
The authors develop a model based on Bhattacharyya whereby managerial quality is unobservable to shareholders, and therefore first‐best contracts are not possible. In the second‐best world, compensation contracts motivate high quality managers to retain and invest firm earnings, while low quality managers are motivated to distribute income to shareholders. These hypotheses arising from the model are tested on data for Canadian firms' dividend payouts over the period 1993‐1995 using tobit regression analyses.
Findings
Consistent with the predictions of the Bhattacharyya model, the results show that, ceteris paribus, earnings retention (dividend payout) is positively (negatively) associated with executive compensation. These results hold when payout is defined as common dividends plus common share repurchases.
Research limitations/implications
The Canadian data provide only limited information on the components of executive compensation. A more useful test would be possible with more detailed information on, for example, salary, bonus, and benefits.
Originality/value
Several recent papers have documented an association between dividends and executive compensation. This paper presents and tests a model that provides a potential explanation for this link.