INSIDE DEBT ON FIRM VALUE

Inside Debt on Firm Value



Introduction

Since the financial crisis in previous years, executive compensations were considerably examined by the public in order to avoid excessive or inadequate structure of compensations would damage the right of the firms' shareholders and debt holders. In the process of pursuing optimal compensation scheme, how to determine the relative proportion of debt and equity compensation is one of a key factor, almost over the past three decades, most of the literatures advocated the equity-based compensation (Sundaram, 2007).

However, this compensation structure could not effectively resolve the problem of agency cost of debt (Edmans, 2010). In recent years, the debt-like incentive plans such as defined benefit pensions and deferred compensations gradually play an important role among the top managers compensation scheme especially in the United States. I will present further discussion in the following in Section 2 and Section 3.

Inside debt role in compensation scheme

The inside debt is the debt held by the corporate executives. It is mainly comprised by deferred compensation and determined reimbursement retirement fund, which are not tenable, unfunded responsibilities, and possess equivalent assertive priority among external creditors when the firm confronts with bankruptcy (Edmans and Liu 2010). Both of two represent the feature of constant indebtedness payable by the organisations and promise to pay to their executive directors fixed amount of payoff in the future, in addition, the executives are able to enjoy deferred taxation benefit (Yermack, 2011).

Managerial incentives can be segmented by two categories of equity-based and debt-based respectively. The stocks and other financial products such like (bonds, TFCs, etc…) are included in equity-based compensations and the value of instruments will be related to the equity value in the future, while the debt-based compensations are instruments like pensions. Jenson and Meckling (1976) proposed the theory of agency cost of debt. This theory demonstrated the conflicts between owners (debt holders) and agents (managers or executives) which are aroused by different strategies in investment policy, dividends payout policy and capital structure (Jenson, 1976). Therefore, equity-based compensations proved to be inadequate solutions to decrease the organizational rate of liability and lower the risks of wealth transfer from shareholders to debt holders. With adding debt to the compensation scheme, there would be less motivation for the executives to transfer wealth from debt holder to shareholder (Sundaram and Yermack 2007). Inside debt has been widely used for CEO compensation in recent years, ...