Performance choice, executive bonuses and corporate leverage

This study examines the causal link between a firm's leverage decisions and the characteristics of its CEO bonus plans. Results from a simultaneous equations model strongly suggest that highly levered firms are less likely to use return on equity (ROE) or ROE-based accounting performance measures to determine executive bonuses. Estimates also indicate that firms with fewer debt covenants, higher interest rates on debt, and a greater proportion of executive pay in the form of stock options are less likely to adopt ROE-based measures for use in CEO bonus plans. These findings lend strong support to the efficient contracting hypothesis. The conflicting interests of corporate stakeholders, especially between stockholders and creditors, encourage firms to tie executive pay to performance metrics like return on assets (ROA) that will strike the optimal balance between the agency costs of debt and the agency costs of equity.