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Leverage, executive incentives and corporate governance

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  • The author would like to thank his colleagues Professor Robert Durand at Curtin University and Professor Richard Heaney at the University of Western Australia for their invaluable comments and feedback. The author would also like to thank his colleagues in Accounting and Finance Discipline Group at the University of Western Australia for their comments and feedback. The initial draft of this paper won the best paper award in the corporate governance stream at the 2010 AFAANZ Conference in Christchurch, New Zealand. I would like to thank my paper reviewer(s) who nominated this paper for the best paper award. I would also like to thank my paper discussant, Associate Professor Keith Duncan from Bond University, and all participants at the 2010 AFAANZ Conference for their comments and feedback. Thanks are also due to Professor Ender Demir and all participants at the 2010 EBES Conference for their feedback and suggestions. I am also thankful to all participants at the UWA Business School Forum for their comments and feedback. Many thanks also to Professor Terry Walter, Dr Dirk Baur and all participants at September 2010 seminars at the University of Technology-Sydney for their comments and suggestions. All errors are mine.

Abstract

This paper analyses the effect of executive incentives and internal governance on capital structure. Using a large sample of non-financial US-listed firms over the period 1999–2005, it is found that managers have different attitudes towards leverage when offered different incentive schemes; leverage initially decreases in bonuses and stock incentives and then increases in these incentives after a certain incentive level, suggesting the existence of the entrenchment–alignment effects under these incentive schemes. In contrast, leverage initially increases in option incentives and then decreases after a certain option incentive level. When all of these incentive schemes are combined together into a single incentive package, the entrenchment–alignment effects prevail. It is also found that leverage increases in internal governance and managers behave differently under different governance regimes such that the entrenchment–alignment effects prevail under weak governance firms, whereas the alignment–entrenchment effects prevail under strong governance firms. The results also suggest that managers’ target leverage ratio is less than the one predicted by theory or preferred by firm shareholders.

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