CEO Compensation and

Leverage Ratio

A BSc International Business Thesis

Written by Remco Mul
ANR 235591
Supervised by
Vincent van Kervel

Content
Content.......................................................................2
Chapter 1 Introduction...........................................3
Chapter 2 Literature Review..................................7
Chapter 3 Research Method..................................9
Chapter 4 Results.................................................14
Chapter 5 Conclusions........................................18
Chapter 6 References..........................................20

Chapter 1 Introduction
On the issue's background and the problem statement
CEO Compensation has been a hot item during the ongoing financial crisis, especially
concerning the incentives which ensue from specific payment schemes. Central to this debate
were the exorbitant boni which especially CEOs received while their performance left a lot to be
desired. This was often found to be combined with the questioned ethical standards of both the
firm and the CEO. In the light of these developments it is interesting to delve into the subject of
managerial compensation. This thesis will not elaborate on the moral side of this issue, rather it will
take a more investigative approach. The relationship being investigated is whether firms with a
more risky capital structure are more likely to pay their CEO's with a compensation scheme which
implies the incentive for more risk taking behavior. The CEO compensation scheme will be defined
by the variable of change in CEO compensation ratio as defined by options and bonus divided by
total compensation, which consists of the former two components and fixed salary. The capital
structure of the firm will be represented by the leverage ratio of the firm constructed by the total
debts over total assets ratio. In addition, the variables of option volatility, stockholder's equity and
change in stockholder's equity of the firm will be included to indicate other underlying factors of the
CEO option portfolio. These variables will be analyzed in order to find a relationship between them
and subsequently conclude that any measures taken concerning the CEO's compensation scheme
to change the incentives of a CEO will need to be accompanied by a change in the capital
structure of the firm and visa versa.
Research Questions
The following set of questions comprise the extend of the research conducted. Over the
course of the chapters the aim is to answer these questions properly, thoroughly and extensively.
In the final, concluding chapter the answers to these questions will be provided. The questions are
ordered on generality starting with the most general question.
1. Does the average value of options owned by the CEO differ substantially between the
highest decile firms by leverage ratio and all the observed firms in the sample?
2. Is there a relationship between the change in CEO compensation ratio and the change in
leverage ratio of the employing firm?
3. Is there an industry specific effect between the change in CEO compensation ratio and
the change in leverage ratio of the employing firm?

4. Are extremely leveraged firms more risk seeking than highly leveraged firm, as indicated
by the relationship between the change in CEO compensation ratio and the change in leverage
ratio of the employing firm?
The first questions functions to give a preliminary indication on the non-linearly relationship
between CEO compensation ratio and leverage ratio, not yet controlled for any biases. The second
question is the question of primary interest and explores the relationship of primary interest
between managerial compensation and the firm's capital structure. The third questions answers
the second question, but then on a per industry basis. The last question explores whether taking
an even higher cap of leverage ratio will change the relationship observed in question two.
Theoretical Framework

Graph 1 Theoretical Framework

Dependent Variable - Change in CEO Compensation Ratio

This variable functions to model the risk imbued in the CEO's compensation scheme. This
variable is determined by the independent variable Leverage Ratio. The variable is constructed by
the components of options, bonus and total compensation. Options comprises a variable
component of stock securities, which value is determined by the performance of the firm. Bonus
comprises a variable component of the total compensation, based upon contractually determined
performance indicators, which differ on the individual CEO's basis. Both serve the goal of
determining the CEO's behavior and incentives. The final component, total compensation, consists
of the former two components of bonus and options, in addition to salary, which is a contractually
fixed payment not determined by any independent factor or performance indicating measure. The
higher this variable the higher the implied risk imbued in the CEO's compensation scheme.
Independent Variable - Change in Leverage Ratio
This variable functions to model the risk imbued in a firm's capital structure. This variable is
constructed by the components of Debt and Total Assets. Debt comprises the total liabilities on the
credit side of a firm's balance sheet. Total Assets comprises a firm's total assets, i.e. its credit side,
on its balance sheet. The variable Leverage Ratio is then calculated as Debt divided by Total

Assets. The higher the variable the higher the implied risk imbued in the firm's capital structure.
Moderating Variable - Firm's Industry
The variable functions to control for the industry of the firm. This variable is constructed by
classifying each industry to one of ten industry categories. This variable moderates the relationship
between Leverage Ratio and CEO Compensation Ratio and will therefore function as a control
variable.
Moderating Variable - Firm's Option Volatility
This variable functions to control for the effects option volatility of the firm on the option
component of CEO compensation ratio. This variable moderates the relationship between
Leverage Ratio and CEO Compensation Ratio and will therefore function as a control variable.
Moderating Variable - Firm's Size
This variable functions to control for the firm's size. This variable is constructed by
measuring the Stockholder's Equity on the firm's balance sheet. This variable moderates the
relationship between Leverage Ratio and CEO Compensation Ratio and will therefore function as a
control variable.
Moderating Variable - Firm's Performance
This variable functions to control for the effects of firm's performance. This variable is
constructed by measuring the yearly change in Stockholder's Equity on the firm's balance sheet.
This variable moderates the relationship between Leverage Ratio and CEO Compensation Ratio
and will therefore function as a control variable.
Preliminary Theoretical Assumptions
These are the preliminary theoretical assumptions, which will be expanded and elaborated
in chapter 2 and 3. They are mentioned here now as a preliminary overview and introduction.
1. The relationship between CEO compensation ratio and leverage ratio is non-linear and
most prominent with very high leverage ratios.
2. Firms decide on their own leverage ratios.
3. Industries tend to have common industry leverage ratios, for which control takes place by
selecting highest decile firms according to leverage ratio of each industry.
4. CEOs risk incentives can be regulated by the reward of options, which is regulated by the
firm.

Research Method
The nature of the research problem as defined in the problem statement allows for the
conduction of causal research, as opposed to descriptive research. Causal research requires
narrowly defined variables and a clear relationship among these variable, as well as a theoretical
framework linking these variables. In addition, descriptive research will be used in chapter 4 for
some preliminary indication for further results. For the data collection the Compustat North America
database will be addressed using the S&P data set.

Chapter 2 Literature Review

Concerning the theoretical elaboration on this paper, it's important to distinguish two rather
separate elements of issue studied at hand. Firstly the CEO compensation and secondly the firm's
capital structure. The primary interest in CEO compensation concerns how the compensation
scheme is designed and what incentives are imbued in such a scheme. Interest in the capital
structure is both in the leverage of the firm and to what extend firm performance and incentive can
be derived from the capital structure. Only by carefully considering these two elements and how to
deal with them can the research questions in this paper be properly answered.
Literature on Managerial Compensation
The most obvious issue to address for CEO compensation is whether more compensation
enhances performance or motivation any way. This common fallacy basically addresses the issue
whether incentives are determined by absolute or relative amount, or a combination. According to
Jensen & Murphy (1990) the total amount of compensation is not related to behavioural incentives,
while the method the compensation is constructed is very important.
They continue with three major components how to govern CEO incentives. First, by
salaries, bonus and stock options for performance rewards. Second, by making CEOs substantial
owners of company stock. And last, by creating the thread for dismissal by poor performance. The
first component will be the main focus of this paper, to understand the empirical relationship
between CEO compensation and capital structure. While the focus on options is of great
importance, this paper will not focus on the second component, because this is an extension of the
first component and only of interest for a longer term perspective. The third component is in daily
practice not actually utilized, as CEO is not a very risky job. (Jensen & Murphy, 1990) Even while
CEOs may be fired or step down, they often manage to find another similar paid job, which
negates this third incentive component.
While the absolute amount is not altering incentives, as opposed to actual compensation
scheme, regulating incentives will increase the total compensation. This is due to two separate
reasons. Firstly, each component of the compensation needs to be substantial in order to actually
alter incentives. Secondly, due to a natural selection system only the best performing CEOs will
remain and their superior performance will earn them a higher compensation.
According to Core et al. (2003), there exist two main research streams on CEO incentives.
The first stream is primarily used in finance and economics, while the second stream is mainly
found in the accounting literature. The first stream assumes that firms use stock price as the sole
performance measure in CEO contracts and considers both the CEO's annual pay and the change
in the value of the CEO's equity portfolio when estimating total CEO compensation. The second
stream recognizes firms use multiple accounting-related performance measures in CEO contracts.

Literature on Capital Structure

On the issue of how firms choose their capital structure, there are two theories: Agency
Theory and Transaction Cost Economics. (Kochhar, 1996)
Agency theory goes as follows: The creation of debt reduces the agency costs of free cash
flow by reducing the amount available to managers. If they spend the free cash on wasteful
expenditures, the probability that the repayment schedule will be met decreases. This threat
prevents managers from undertaking wasteful actions and they aim to utilize assets efficiently,
increasing firm value. So, this implies that an appropriate capital structure functions to control
manager's wasteful incentives.
This aligns well with this paper, since the relationship studied at hand is whether a more
debt heavy capital structure does lead to more risk incentives embodied in the CEO's
compensation.
Concerning Transaction Cost Economics, Kochhar explains that the the choice between
equity and debt depends on firm structure. If firm managers default on some or all of their
contractual obligations, debt holders may push the firm into bankruptcy. As is their right, they would
aim to recover their investment by liquidating assets and selling them to another firm which can
utilize them for the original or a different purpose. The loss in investment will be greater the higher
is the level of firm specificity. For example, real estate generally has a low firm-specificity while
R&D tends to have high firm-specificity. Therefore, debtholders will be unwilling to invest in projects
with high firm-specific assets, and prefer low-specificity investments. Finally, Titman and Wessels
(1988) found that a firm's leverage was negatively related to product uniqueness, a measure of
firm specificity. These findings lend support to the link between specificity and capital structure.
This factor would influence the capital structure of a firm beyond just the amount of risk
incorporated into it. This would pose a problem to the assumptions of this paper. However, firms
will be classified according to industry. To a certain degree, this will dilute the effect of specification.
This would render an overall balanced sample.

Literature on the relationship between Managerial Compensation and Capital Structure

Past studies have expanded upon the CEO and capital structure relationship. Wanzenried
(2003) explored the relationship between capital structure inertia and CEO compensation. While
that aim is not the same as this paper's aim, there is a similarity to what degree the CEO's
compensation influences an aspect of the capital structure. Wanzenried uses four variables to
determine the strength of CEO incentives: Option ratio; Pay-performance sensitivity; Size of
variable component; Firm ownership. In the paper, it is confirmed that CEO incentives and capital
structure are related, to the extend of the measure of capital structure inertia. However, it is
relevant for this paper that both components are proven to be empirically related. This paper will
extend upon that. Also, this paper confirms that the measures used for measuring the CEO
incentives in this paper were found adequate by Wanzenried.

Chapter 3 Research Methods

In the process of trying to prove a relationship between CEO compensation and capital
structure regarding risk incentives, there are a few theoretical baselines established. These
assumptions function to provide more reliable test results while not altering the theoretical
framework which was described in the first chapter. At the same time, the theoretical framework will
be slightly extended and elaborated. In addition, the motivations and expected results concerning
the experiments and analysis in the next chapter will be laid out.
Theoretical assumptions

First of all, it is important to realize why certain companies choose certain capital structures.
In chapter two there were two theories which have been elaborated. First of all, the transaction
cost theory implies that firms will choose less leverage the more the firm is specified. This effect is
due to when a firm defaults on its debt, its liquidated assets will be worth less due to their
specificity. The specificity effect is peculiar to each industry: Some industries require more
specified assets than others. This causes a bias in the sample such that certain industries will be
overwhelmingly favored over others, such that the sample in no longer representative. In order to
remove this bias we control for industry effects by dividing the sample in ten categories using
Standard Industry Classification codes. Within each industry category, we select the highest ten
percent according to their leverage ratio. This ensures that the original ratio of companies per
industry classification is maintained, while controlling for the industrial bias otherwise introduced in
the sample.
A second bias which might be introduced into the sample is that bad performing companies
suffer a loss in share price, decreasing the Shareholder's Equity item on the balance sheet. This
would cause an increase in leverage ratio, as calculated by Liabilities divided by Assets. This is an
unwanted bias in the sample, because the relationship researched at hand is whether companies
with higher leverage ratio due to increased risk incentives provide their CEOs with more risk taking
incentives via their compensation scheme. In order to control for this bias, we include a variable for
the relative change in equity. This should measure the effects of bad performance, while
simultaneously measuring the leverage ratio.
Using these measures to rid the sample of biases this leaves one category of companies,
which choose their capital structure to have a high leverage ratio. The highest ten percent
according to leverage ratio is selected, in order to reveal so called 'gambling for resurrection'
patterns which are associated with highly leverage firms. Gambling for resurrection entails highly
leveraged firms which face imminent bankruptcy are willing to engage in highly risky projects with a
very high potential payoff, but at the risk of defaulting on its debt. These risky projects are taken at
the expense of more safe projects which would ensure a secure payoff, but would guarantee in a

low value for the shareholder's, because the payoff would be used to payoff debt. Effectively, this
effect shifts wealth from the debtholders to the shareholders. Since this effect only occurs among
high leveraged firms, there is no linear effect and only the highest ten percent is selected. These
are the companies which will be used for the empirical experiments.
There is a number of variables which can be utilized to measure the risk incentives imbued
in the CEO compensation, but it all boils down to measuring a change in stock options as owned
by the CEO. In the end, the variable was settled to contain the component of Options as primary
indicator of risk incentives. Then, it's crucial to measure the change over time of this variable and
compare it to the change of the leverage ratio, which indicates the risk imbued in the firm's capital
structure. In addition to using the value of the CEO's option stock, it's prudent to include bonus as
well. This component is significantly more static due to its contractual nature and predefined
bounds, but nevertheless it adds to the risk incentives imbued in the total compensation. In order
to give the amount of options and bonus a frame of reference, it's used as a ratio against total
compensation. In addition to the previous two components, the total amount of compensation is
also included in the analysis. Stock held by the CEO gives incentives to reduce risk. Since we aim
to measure CEO incentives to take on more risk, this measurement is not incorporated.
With regard to the measure used for indicating CEO compensation and the imbued risk,
options form a crucial element. One element in the value of these options is the volatility of the
option portfolio. Increases in volatility represent an increase in uncertainty. For an option, an
increase in volatility generally is followed by an increase in price. This is due to a potential larger
pay-off for the option when it is 'in-the-money'. Since the stock option portfolio is one component of
measuring the CEOs risk incentives via a change in his compensation ratio, it is expected there is
a positive correlation between change in volatility and change in CEO compensation ratio. With this
in mind, the variable Option Volatility is introduced. Unfortunately, for the purpose of this research,
the available data for option volatility is very limited. When the variable Option Volatility is included,
there is a reducation in available observations used for the regression. In addition, this leads to the
exclusion of the SIC category of Public Administration when researching the implications of this
variable.

Theoretical Framework
This is a discussion of the variables used and the methods used to construct them. They
are ordered in order of appearance in chapter 4.

CEO compensation:

Options Bonus
Total Compensation

This variable representing CEO compensation consists of a number of components. The

most important component is Options, which consists of the estimated dollar value of unexercised
options owned by the CEO. The reason this is labeled as the most important component is
because a CEO can exercise influence on this component himself by conducting projects and
exercising decisions of a more risky nature in order to increase the value of the options. The
second component is Bonus, which represents the contractually established bonus compensation
for company performance. By its definition, it's less relevant to the relationship studied. The last
component is Total Compensation, which consists of the previous two components but also
contains the component of Salary, which is a fixed amount payed to the CEO and does not depend
on a performance indicator. In order to make a relevant observation, the change of the ratio will be
utilized, so we can observe whether a change in capital structure results in a change in CEO
compensation ratio.

Leverage Ratio:

Liabilities
Assets

This variable measures the change in leverage ratio for the company. It's first component consists
of Liabilities as total liabilities on the balance sheet of the firm. The second component consists of
the total Assets as total assets on the balance sheet of the firm (which equals the sum of total
liabilities and stockholder's equity by definition). We then use the change in this leverage ratio to
investigate the relationship between a change in capital structure to a change in compensation.
SIC Dummies: D1, D2, ... , D9
To represent the industry effect on the correlation between executive compensation and
capital structure, each company will be classified according to their SIC code. This is a number
which ranged from 0100 to 9995 and represent a certain industry of business. Each number range
ranging from 0-999, 1000-1999, etc represent a major classification of the industry of each
company, as opposed to the rather precise complete number. For this reason, nine dummy
variables will be used to calculate industry effects.1

1Company's classified from 0-999 are the base number 0. The following industries are included and labeled in their respective order:
SIC Category 0: Agriculture, Forestry, Fishing, SIC Category 1: Mining, SIC Category 2: Construction, SIC Category 3: Manufacturing,
SIC Category 4: Transportation, Communications, Electric, Gas and Sanitary Services, SIC Category 5: Wholesale Trade, SIC Category
6: Retail Trade, SIC Category 7: Finance, Insurance and Real Estate, SIC Category 8: Services, SIC Category 9: Public Administration.

Option Volatility: Option Volatility

The variable option volatility indicates the volatility of the options stock possessed by the
CEO. This variable provides a further refinement of indicators of the CEO compensation ratio. It
serves to investigate whether there is a relationship between a change in the option volatility and a
change in the CEO compensation ratio. Since options are a major component of the ratio, it is
expected there should be a correlation present. This variable was not widespread available, which
amounted to only 7700 observations of option volatility out of 39.000 total observations (after
further selection as described in the theoretical assumptions this amounts to 720 observations).
Any analysis utilizing this variable in the coming chapter will not contain the SIC category 9
dummy, for which only 22 observations are available.
Firm Size: Equity
In order to control for the effects of firm size on the CEO compensation ratio, the variable
Equity is introduced to represent the firm's size. The larger the company, the more able it is to give
it's CEO a higher compensation. In order to control for this effect, this variable is introduced. Since
a larger company would be able to afford a higher compensation, this variable is expected to be
positive in the regressions in the subsequent chapter.
Firm's Performance: Equity
The change in equity serves to control for the element of 'loser' companies. The selected
companies have a very high leverage ratios, which often means they are at the brink of bankruptcy.
This means that their equity suffers a decrease, which lowers the value of the option stock of the
CEO while it increases the the leverage ratio. This results in a negative relationship between the
leverage ratio and the change in CEO compensation. In order to control for this relationship the
variable of change in equity is introduced.
In addition to this effect, the change of equity can provide a rough estimation of the share
price of the company, and therefore of the value of the options of the company. Thus, it is a
relevant variable to include into the analysis to provide an indicator how CEO compensation ratio
might fluctuate with share price, and therefore will provide a another control variable for how the
CEO's option stock might change.
Research Methods
For the research a total sample set of 39.044 observations is used, retrieved from the
WRDS Compustat North America database. This sample set consists of approximately 2.300
companies with data on CEO compensation, balance sheet items, SIC codes and option volatility
from 1992 till 2008. This data will then be further specified by selecting the highest decile of

leverage ratio within each SIC category, which will be used to perform the analysis in the next
chapter.
A crucial element in the research consists of the temporal element introduced in the
sample. The data set of a large set of companies, with data on each company from 1992 till 2008
concerning their CEO compensation and a number of company-specific balance sheet variables
and their SIC codes. Using these 17 years the change of the leverage ratio, the market value of
equity and the CEO compensation can be calculated of an extended period of time. Conducting
experiments with lagged variables in this manner can indicate whether increases in leverage ratio
are accompanied by increases in risk incentive components in CEO compensation.

Chapter 4 Results
Option Mean Comparison
The following analysis serves to obtain a rough, preliminary estimate of the effects of
leverage ratio on CEO compensation. It consists of a simple comparison of the mean of the dollar
value of options owned between all the firms observed versus the highest decile of firms, while
controlling for industry effects via the SIC dummies. The highest percentile of firms are theorized to
be over-leveraged compared to the whole sample of firms and more likely in the situation of
imminent failure. The purpose is to get a first crude impression of the effects at hand, which are
multifaceted. First of all, it can be expected that higher leverage ratio will result in a higher value of
the CEO's option stock, due to increased risk incentives. Secondly, such over-leveraged firms can
be expect to be under performing, as explained in the prior chapter. This will result in a decrease in
the value of the CEO's option stock. Lastly, the volatility of an over-leveraged firm is higher than
the common situation, resulting in an higher value of the CEO's option stock. Overall, the expected
results are ambiguous. However, the result of the comparison will indicate which of these two
effects is dominant. The results are listed below.

Mean of value options of CEO (in dollars)

Complete Sample

11990,51

Highest Decile by Leverage Ratio

6503,55

Table 1 Option Mean Comparison

The mean of the highest percentile of leverage is substantially lower than the overall mean
of the whole sample. This would indicate that the bad performance effects of over-leveraged firms
is dominant over the increase in volatility or the increased risk incentives given to CEO's of high
leveraged firms. In subsequent tests there will be control for these effects, to a certain degree, in
order to attain more revealing results.
Analysis on Highest Decile

Options Bonus
Liabilities
=01
2SIC 13SIC 2 4SIC 35SIC 46SIC 5
Total Compensation
Assets

7SIC 68SIC 7 9SIC 810SIC 9 11Option Volatility 12Equity13 Equity

This regression is the most straightforward equation to find answer to our first research
question and is performed on the highest decile of firms as ordered by their leverage ratio. It
explores the question whether and how a change in capital structure in favor of more leverage
relates to a change in CEO compensation in favor of more risk taking behaviour. In addition, we

include the SIC dummies to investigate whether industrial biases with regard to this relation play
any significant factor. The variable Option Volatility is used to control the correlation between option
volatility and option portfolio value within the compensation of the CEO. The next variable,
Stockholder's Equity, controls for firm size. Lastly, the variable change in Stockholder's Equity
controls for changes in firm's market performance on CEO compensation and ensures that we
control for 'loser' firms, which were defined under Firm's Performance in the former chapter.
Beta

Significant (within 95%)

Constant

9,28E-018

No

Leverage Ratio

-0,047

Yes

SIC Category 1

-0,183

Yes

SIC Category 2

-0,160

Yes

SIC Category 3

-0,125

Yes

SIC Category 4

-0,174

Yes

SIC Category 5

-0,183

Yes

SIC Category 6

-0,208

Yes

SIC Category 7

-0,196

Yes

SIC Category 8

-0,157

Yes

Option Volatility

0,001

Yes

Equity

1,484E-5

Yes

Change in Equity

1,832E-6

Yes

Table 2 Analysis on Highest Decile

The results are nothing short of surprising. Our main variable of interest, the change in
leverage ratio, is both significant and negative. The results imply that a 1 percentage point increase
in leverage ratio of the firm will result in a 0,047 percentage point decrease in CEO compensation
ratio. This implies that, as far as CEO's can decide on capital structure, CEO's have no incentives
to increasing leverage ratio. Industry effects for all other SIC categories experience this effect even
stronger. As expected, Option Volatility is a positively related variable but relatively small compared
to the change in leverage ratio. Firm size is, while small, significant and positively related to the
compensation ratio, which is also according to expectations. Lastly, the change in Stockholder's
equity is, while small as well, significant and positively related. This is a sensible result, since an
increase in share price would imply an increase in option value.
It must be noted that due to the lack of data it was, unfortunately, not possible to maintain
the inclusion of the SIC category 9 dummy in this analysis, which was public administration. This is
due to a lack of data for the variable for Option Volatility. For subsequent analysis, where this
equation is compared to the highest two percentile leverage ratio of firms, the variable Option
Volatility will not be included. This decision is made in order to ensure that the sample size remains
substantial and to make the comparison reliable. In that light, the following section contains the
same regression, but without the variable of Option Volatility.

Comparison of Highest Decile and Highest Two Percentiles

Options Bonus
Liabilities
=01
2SIC 13SIC 2 4SIC 35SIC 46SIC 5
Total Compensation
Assets

7SIC 68SIC 7 9SIC 810SIC 9 11Equity12 Equity

This regression is identical to the regression in the former section, save for the exclusion of
Option Volatility. This regression is performed on the highest decile of firms as ordered by their
leverage ratio.
Beta

Significant (within 95%)

Constant

-2,707E-5

No

Leverage Ratio

-0,042

Yes

SIC Category 1

-0,062

Yes

SIC Category 2

-0,041

Yes

SIC Category 3

-0,016

Yes

SIC Category 4

-0,009

No

SIC Category 5

-0,044

Yes

SIC Category 6

-0,040

Yes

SIC Category 7

-0,035

Yes

SIC Category 8

-0,066

Yes

SIC Category 9

-0,004

No

Equity

-1,696E-6

Yes

Change in Equity

1,329E-5

Yes

Table 3 Comparison Table of Highest Decile

The overall results are very similar compared with the regression including Option Volatility.
There a few notable changes. The SIC dummies are all smaller and the SIC Category 4 and 9
dummies are both not significantly different from zero. In addition, there is the curious result that
Firm's Size is now negatively related to the CEO compensation ratio.
Now follow the results of exactly the same regression, except it is performed on a sample of
the highest two percentile firms as ordered by their leverage ratio.

Beta

Significant (within 95%)

Constant

-5,974E-6

No

Leverage Ratio

-0,030

Yes

SIC Category 1

-0,022

Yes

SIC Category 2

-0,107

Yes

SIC Category 3

-0,022

Yes

SIC Category 4

-0,048

Yes

SIC Category 5

-0,020

Yes

SIC Category 6

-0,036

Yes

SIC Category 7

-0,042

Yes

SIC Category 8

-0,104

Yes

SIC Category 9

-0,002

No

Equity

-1,846E-6

Yes

Change in Equity

9,235E-6

Yes

Table 4 Comparison Table of Highest Two Percentile

Compared to the regression performed on the highest decile, this regression's correlation
between the change in leverage ratio of the firm and the change in CEO compensation ratio is less
negative, implying there is an overall positive effect by taking more leveraged firms. The results
imply that a 1 percentage point increase in leverage ratio of the firm will result in a 0,03 percentage
point decrease in CEO compensation ratio. This implies that CEO's would still have no incentives
to increasing leverage ratio, but these incentives are less strong than in former case of the highest
decile. There are a few possible, not mutually exclusive, explanations for this. First of all, it could
be that further increases in leverage ratio are not very much related to firm's performance, not
causing a change in the value of the CEO's option stock. Second of all, the option volatility could
have a significant larger effect than in the former case. Lastly, the firm could attempt to increase
the CEO's risk incentives by an increase in the value of the options owned by the CEO.
The other variables are, while slightly different in value, all very similar to the former
regression on the highest decile. The only notable change is that the SIC category 4 dummy is now
significant, leaving only SIC Category 9 to be not significantly different from zero.

Chapter 5 Conclusions
Results

In the former chapter the results of the study have been presented. Now the research
questions as stated in chapter one will be answered using these results, in the same order as
chapter one. The first research question is "Does the average value of options owned by the CEO
differ substantially between the highest decile firms by leverage ratio and all the observed firms in
the sample?". The results indicated there was indeed a substantial difference. This would indicate
that the bad performance effects of over-leveraged firms is dominant over the increase in volatility
or the increased risk incentives given to CEO's of high leveraged firms.
The second research question is "Is there a relationship between the change in CEO
compensation ratio and the change in leverage ratio of the employing firm?". It appears
that indeed, there is a relationship, which is negative. The results imply that a 1 percentage point
increase in leverage ratio of the firm will result in a 0,047 percentage point decrease in CEO
compensation ratio. This implies that, as far as CEO's can decide on capital structure, CEO's have
no incentives to increasing leverage ratio.
The third research question is "Is there an industry specific effect between the
change in CEO compensation ratio and the change in leverage ratio of the employing
firm?". The results imply that there are indeed significant industry specific effects on the
relationship between the managerial compensation and the capital structure of the firm. In addition,
among industries there are substantial differences in effects of change of leverage ratio on the
CEO compensation ratio.
The fourth research question is "Are extremely leveraged firms more risk seeking than
highly leveraged firm, as indicated by the relationship between the change in CEO compensation
ratio and the change in leverage ratio of the employing firm?". The results would indicate that
extremely leveraged firms are more risk seeking than higly leveraged firms. Compared to the
answer on the second research question, this correlation between the change in leverage ratio of
the firm and the change in CEO compensation ratio for the highest two percentile of firms is less
negative, implying there is an overall positive effect by taking more leveraged firms. The results
reveal that a 1 percentage point increase in leverage ratio of the firm will result in a 0,03
percentage point decrease in CEO compensation ratio. There are a few possible, not mutually
exclusive, explanations for this. First of all, it could be that further increases in leverage ratio are
not very much related to firm's performance, not causing a change in the value of the CEO's option
stock. Second of all, the option volatility could have a significant larger effect than in the former
case. Lastly, the firm could attempt to increase the CEO's risk incentives by an increase in the
value of the options owned by the CEO.

While many variables are correlated to the change in the CEO compensation ratio,
increasing leverage for extremely leveraged firms has a less negative effect on CEO compensation
than highly leverage firms, indicating that high leveraged firms indeed proceed to 'gambling for
resurrection' thereby increasing option volatility. However, the coefficients of the results are
economically small. In addition, there is a lack of control for many other variable, e.g. option
volatility, in the comparison between extremely and highly leveraged firms, leaving many effects to
be entangled simultaneously.
Limitations of the study

There are a number of limitations of the study, which will be elaborate here. The primary
source of the limitations are due to the imperfections of measuring instruments at hand.
First of all, the measurement used for the leverage ratio was computed by the market
values of assets and liabilities. It would have been preferable if instead the percentage change in
book value of debt would be used instead as a measurement for firm leverage. Market value of
debt is subject to changes in value according to market fluctuations. Book value of debt has the
advantage it captures the conscious decision of the level of debt by the firm. The percentage
change would then control for firm size and emphasize relative large and intentional increases in
the level of leverage. Unfortunately, data on book value of debt was not readily available and thus
this measurement for capital structure could not be implemented.
Secondly, the measurement used for CEO compensation suffers from the same
dependence on market value. In order to partially control for this, variables like Option Volatility and
Change in Equity were introduced. However, these measures are merely patches on to mitigate an
inherent problem. Instead, it would have been preferable to have book value of options owned by
the CEO, which does not suffer from these imperfections.
Thirdly, the availability of the variable Option Volatility was limited to the degree it wasn't
possible to answer all research questions using the variable. In addition, the SIC category 9
couldn't be researched at all combined with this variable due to too little samples. A more complete
sample of Option Volatility would be prudent to further mitigate for the limitations of the variable for
CEO compensation.
Further research
There are several ways further research could improve on the research as presented here.
The most obvious method would to implement suggestions or mitigate limitations as suggested in
the former sections Limitations of the study. In addition, the results indicated a negative
relationship between leverage ratio and CEO compensation ratio, which was contrary to
expectations. This shows that there is more going on than revealed by this paper and would
provide a window for further research.

Chapter 6 References
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Business Review, May-June 1990, No.3, pp 138-153.
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Kochar, R. (1996), Explaining Firm Capital Structure: The Role of Agency Theory vs Transaction
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Finance, Vol. 43, No. 1 (Mar., 1988), pp 1-19.
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