Financing decisions when managers are risk averse: The effects of incentive compensation on firms' capital structure choice

This study investigates the impact of financing decisions on risk-averse managers. Leverage raises stock volatility, driving a wedge between the cost of debt to shareholders and the cost to undiversified, risk-averse managers. This paper is the first to quantify these ‘volatility costs’ of debt and to examine their impact on financing decisions. I show that (1) the volatility costs of debt can be large, particularly if the CEO owns in-the-money options; (2) in-the-money options tend to decrease, rather than increase, managerial preference for debt; (3) the volatility costs of debt are sensitive to firm characteristics and the CEO's stock and option portfolio; and (4) a stock price increase tends to reduce managerial preference for leverage (consistent with prior evidence on security issues). Empirically, I estimate the volatility costs of debt for a large sample of U.S. firms and test whether these costs affect financing decisions. I find strong evidence that volatility costs affect both the level of and short-term changes in debt. Further, a probit model of security issues suggests that managerial preferences help explain a firm's choice between debt and equity.