Executive compensation, asset substitution problem and investments in risky projects

Compensation studies suggest that equity-based compensation can align the interests of shareholders and managers in terms of managerial risk taking choices. This study extends the literature by examining whether equity-based compensation is used to incorporate the interests of bondholders with those of managers and shareholders in terms of managerial risk taking. In particular, it hypothesizes that equity-based compensation induced managerial risk taking are different for firms with and without asset substitution problems. Using simultaneous equations models (SEMs) with CEO compensation from 1929--2004, the data shows that CEOs act differently for firms with different financial structure and different ex ante financial distress risk. The sensitivity of CEO wealth to stock returns volatility ( PRS) has a lower impact on managerial risk taking for debt-financed firms relative to all-equity firms, and a lower impact for high distress risk firms relative to low distress risk firms. Additional analyses indicate that for firms using convertible debt to reduce the asset substitution problem, options-based compensation do not have different impacts on firms with or without asset substitution problem.