Are Debt and Incentive Compensation Substitutes in Controlling the Free Cash Flow Agency Problem?

Authors

  • Yilei Zhang

    1. Yilei Zhang is an Assistant Professor in the College of Business and Public Administration at the University of North Dakota, Grand Forks, ND.
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  • I am grateful to Matt Billett, Jon Garfinkel, David Mauer, Yiming Qian, Jay Sa-Aadu, Anand Vijh, and an anonymous referee for many helpful comments and suggestions. I thank seminar participants at the University of Iowa, the University of Texas at San Antonio, Kansas State University, Loyola University Chicago, the University of Toronto, and the University of North Dakota. I also thank Wendy Jennings and Michael O’Doherty for careful editing and proofreading. All errors are my responsibility.

Abstract

This paper investigates the governance implications of a firm's capital structure and managerial incentive compensation in controlling the free cash flow agency problem. The results suggest: debt and executive stock options act as substitutes in attenuating a firm's free cash flow problem; failure to incorporate the substitutability and endogeneity leads to underestimates of the magnitude and economic implication of the disciplinary role of both mechanisms; firm characteristics differ across the prevalence of debt usage versus option usage, suggesting the heterogeneity in the costs and benefits of the monitoring devices; and all the above effects are more pronounced in firms that tend to have more severe agency problem.

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