Substitutional Discipline of Option and Debt: Theory and Evidence from CEO Equity Holding, Capital Structure and Executive Compensation

I develop a principal-agent model to analyze the interaction among CEO’s equity holding portfolio, firm’s capital structure and executive compensation contract. Unlike a strand of literatures in corporate finance investigating only capital structure and compensation contract, this paper asks the question whether executive’s equity option holding and firm’s financial leverage jointly affect manager’s compensation. The optimal solution of this model indicates that either high leverage or high strike price of manager’s equity holding exerts disciplinary control over manager’s behavior. This theory implies a testable hypothesis that manager with low moneyness in her equity option holding is associated with low pay-for-performance sensitivity of compensation contract, but this discipline of high-strike option becomes weaker when the firm has higher level of debt. The empirical result provides cross-sectional evidence supporting this substitutional effect between CEO’s equity option holding and firm’s capital structure in determining the profit-sharing rule in optimal executive compensation. This disciplinary effect is weaker for S&P 500 index member firms probably due to better corporate governance induced by institutional ownership.