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The main objective of our study is to examine the impact of CEOS’ risk incentives vega on firms’ risky financing policy in a dynamic setting. Consistent with Chava and Purnanandam (2010), Dong et al. (2010) and Coles et al. (2006), we find that vega has a significant positive effect on the managerial adoption of debt financing policy after addressing the possible endogeneity problems and controlling for a wide array of CEOs’ risk-aversion proxies in our estimation models. If a riskier financing policy were optimal, then CEOs provided with enough vega should increase firms’ performance.
In addition, our result shows that the cost of CEOs’ risk-aversion such as CEOs’ options moneyness and CEOs’ cash compensation can be substantial. Vega is lower for CEOs with more in-the-money options and more cash compensation. This suggests that in-the-money options and cash compensation can reduce CEOs’ preference for risky corporate policy in capital structure decisions.
To some degree, our results demonstrate that the series of executives’ pay reforms in Australia did influence boards of directors to put CEOs’ contractual incentives in place to alleviate the agency problem. Moreover, the link between firms’ size and book leverage suggests that large firms encourage executives to undertake more risky debt financing.
The results present some important policy implications. First, soft-law makers such as ASX Corporate Governance Council should incorporate more restrictive executive remuneration disclosure requirements regarding option moneyness and tie executives’ pay more closely to equity risk in the best-practice guidelines. Second, shareholders should urge boards of
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directors to redesign executives’ compensation packages. More specifically, remuneration committees should give CEOs more common share grants and/or set the exercise prices of options equal to the spot prices at the options grant date. In addition, cash compensation should be reduced in order to reduce CEOs’ risk-aversion. However, there is no reason to reduce the current level of share options because CEOs’ options portfolio vega leads to an increase in firms’ aggressive financing policy.
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