The Use of Cash Flows in Setting CEO Compensation and the Design of Loan Contracts

This study examines whether the use of cash-flow-based performance metrics (CFM) in setting CEO compensation affects the design of loan contracts. Cash-flow-based performance evaluation can motivate managers to improve cash flows, which potentially enhances the firms’ debt repayment ability and reduces their credit risk. We thus hypothesize that lenders, anticipating this incentive effect of cash-flow-based performance evaluation, offer lower loan spreads and reduce the use of cash-flow-based performance covenants when firms use CFM in setting CEO pay. Consistent with our conjecture, we find that the use of CFM is negatively associated with loan spreads and the use of cash-flow-based performance covenants. These findings remain robust after we account for endogeneity. Moreover, these findings are concentrated among firms facing higher credit risk or higher risk of cash flow shortfalls, supporting the notion that lenders consider internally generated cash flows more valuable when borrowers face higher external financing costs or have greater liquidity concerns. Further, we find that the use of CFM is associated with improvements in cash flow performance and reductions in credit risk, reinforcing the notion that CFM serve as an effective incentive mechanism. The overall evidence suggests that lenders consider the incentive effect of cash-flow-based performance evaluation in executive compensation contracts during the debt contracting process