Capital structure and executive compensation contract design: A theoretical and empirical analysis

Compensation contracts including incentive instruments not only provide executives with positive incentives to increase shareholder wealth, but also create a negative value-dilution effect for existing shareholders. This study investigates this dilemma by conducting a benefit-cost analysis under a proposed structural form valuation framework. Our design mechanism shows that, given their firms' current capital structure, shareholders are always capable of designing an optimal compensation contract to maximize their wealth. Due to the different research issue and assumptions, unlike findings of most previous studies, our model proposes that in a firm with a higher leverage ratio shareholders should provide a contract with higher incentive intensity for managers, and this proposition is supported by the empirical analyses which examine the sample of S&P index firms over the period 1992-2006 after adopting an updated fixed effects model.

► This paper analyzes the dilemma derived from executive compensation packages. ► Our theoretical model shows that higher leveraged firms use more equity compensation. ► We empirically find a positive relation between firm leverage and CEO reward options. ► A new viewpoint of how firms set CEO compensation package is introduced.