CEO Risk‐Taking Incentives and the Cost of Equity Capital

• Author: Cameron Truong,Madhu Veeraraghavan,Yangyang Chen
• Published date: 01 September 2015
• DOI: http://doi.org/10.1111/jbfa.12126
• Date: 01 September 2015

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(7) & (8), 915–946, September/October 2015, 0306-686X

doi: 10.1111/jbfa.12126

CEO Risk-Taking Incentives and the Cost

of Equity Capital

YANGYANG CHEN,CAMERON TRUONG AND MADHU VEERARAGHAVAN∗

Abstract: In this paper, we show that the sensitivities of an executive’s wealth to changes in

stock prices (deltas) decrease the implied cost of equity capital while the sensitivities of an

executive’s wealth to changes in stock volatility (vegas) increase the implied cost of equity capital.

Our findings demonstrate that shareholders understand the risks of firms’ future projects as

embedded in executive compensation and price these risks into the cost of equity capital

accordingly. The findings have strong implications for optimal executive compensation contract

design, project evaluation and cost of capital estimation.

Keywords: executive compensation, deltas,vegas, implied cost of equity capital

1. INTRODUCTION

In response to the significant increase in the use of stocks and options in executive

compensation over the past few decades, a large body of literature has devoted

considerable attention to understanding the role of executive compensation in

corporate governance and firm performance.1Recent studies have also examined how

executive compensation affects managerial behavior and risk-taking decisions. There

is mounting evidence that executive compensation portfolio deltas (the sensitivity of

the stock and option compensation portfolio value to company stock prices) lower

managerial risk preferences (Lambert et al., 1991; Carpenter, 2000; Knopf et al.,

2002) while executive compensation portfolio vegas, the sensitivity of the option

compensation portfolio to company stock return volatility, may increase managerial

risk preferences (Knopf et al., 2002; Coles et al., 2006; Brockman et al., 2010;

Armstrong and Vashishtha, 2012).

∗The first author is from the Department of Banking and Finance, Monash University, Australia and School

of Accounting and Finance, Hong Kong Polytechnic University, Hong Kong. The second author is from the

Department of Banking and Finance, Monash University, Australia. The third author is from the Finance

Area, T.A. PAI Management Institute, India. The authors thank the editor Steven Young for his suggestions

throughout the review process. The authors also thank an anonymous referee for the insightful comments

which significantly improved the paper. (Paper received November 2014, revised version accepted June

2015).

Address for correspondence: Yangyang Chen, W1016, Building 11, Monash University Clayton Campus,

Wellington Road, Clayton, VIC 3800, Melbourne, Australia.

e-mail: yangyang.chen@monash.edu

1 Over the period 1993–2003, executive pay increased sharply with the aggregate compensation to the top

five executives of each of the S&P 1500 firms doubling from 5% to 10% of the aggregate earnings of those

firms (Bebchuk and Grinstein, 2005).

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Prior research has investigated the effects of deltasandvegas on managerial risk

preferences to several firm choices such as risky investment and financing policies

(Coles et al., 2006), firms’ hedging activities (Rogers, 2002; Knopf et al., 2002), firms’

risk-taking in merger and acquisition activities (Hagendorff and Vallascas, 2011),

firm’s financial reporting choices (Cheng and Warfield, 2005; Grant et al., 2009; Chava

and Purnanandam, 2010; Armstrong et al., 2013), firm’s usage of short-term debt

(Brockman et al., 2010) and firm’s cash holdings (Liu and Mauer, 2011). Given that

deltas and vegas can determine several risk-taking aspects of a firm, this study aims to

investigate whether shareholders price managerial risk incentives. In particular, we

examine the relationship between executive compensation portfolio deltasandvegas

and the ex-ante measure of cost of equity capital, namely the implied cost of equity

capital. We focus on the cost of equity capital because of its paramount importance in a

firm’s financing and operating decisions. Furthermore, while prior studies have shown

that management is able to reduce the cost of equity capital by adopting accounting

practices such as voluntary disclosure (Diamond and Verrecchia, 1991; Botosan, 1997;

Leuz and Verrecchia, 2000; Botosan and Plumlee, 2002; Graham et al., 2005; Dhaliwal

et al., 2010) and earnings smoothing (Francis et al., 2004; Verdi, 2006), there has

been no evidence on the relationship between managerial risk incentives as embedded

in executive compensation and shareholders’ perception of these risk incentives as

reflected in the implied cost of equity capital.

Using a comprehensive sample of 11,041 firm-year observations from the S&P 1500

over the period 1992–2009, we construct CEO compensation portfolio sensitivities as

in Core and Guay (2002) to study the association between CEO risk incentives and

the implied cost of equity capital. In undertaking this analysis, we employ four ex-ante

measures of the cost of equity capital, derived from the valuation models of Claus

and Thomas (2001), Gebhardt et al. (2001), Gode and Mohanram (2003) and Easton

(2004). Following Dhaliwal et al. (2005, 2006), Hail and Leuz (2006) and Dhaliwal

et al. (2010), we also employ an average-based measure of the implied cost of equity

capital by taking the equally weighted average of the four individual implied cost of

equity capital estimates. Our hypothesis is that when a CEO has an incentive to increase

the firm’s overall risk by adopting riskier corporate policies and investment projects,

shareholders demand compensation for bearing this excessive risk by increasing the

cost of equity capital.2The reverse happens when the CEO has an incentive to reduce

the firm’s overall risk. In testing these hypotheses, we compute CEO deltas and vegas as

proxies for risk-taking incentives based on the CEO’s personal holdings of the firm’s

stocks and options. On the one hand, CEOs with higher deltas arelikelytodecreasethe

firm’s overall risk and thus lower the cost of equity capital because they have a large

exposure to the firm’s total risk which is not diversifiable (Fama, 1980; Stulz, 1984;

Smith and Stulz, 1985). In addition, higher deltas can reduce the cost of equity capital

through the outcome of the incentive alignment effect. That is, higher deltas motivate

CEOs to work towards increasing shareholders’ wealth, thereby reducing the agency

cost between shareholders and managers.

2 The adoption of riskier corporate policies and investment projects can increase a firm’s systematic risk

and idiosyncratic risk. While we do not aim to disentangle the effects of risk incentives on systematic risk

and idiosyncratic risk, our basic assumption is that the cost of equity capital is an increasing function of the

firm’s overall risk. Evidence is mixed on whether idiosyncratic risk is priced (Botosan, 1997; Botosan and

Plumlee, 2002; Botosan et al., 2004) or not priced (Cohen, 2004; Chen et al., 2004; Nikolaev and van Lent,

2005; Hughes et al., 2007).

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On the other hand, high deltas can expose managers to more risk and managers may

consequently forgo positive but risky NPV (Coles et al., 2006). Also, there is evidence

that managers may underestimate the risk of firm choices because they overestimate

their own abilities (Malmendier and Tate, 2005). Overconfident managers may be

motivated by the upside potential of stock-based compensation and make value-

destroying investments (Goel and Thakor, 2008). This way, high deltas can increase

the cost of capital because managers may not act in the best interest of shareholders.

CEOs with high vegas stand to gain from higher volatility and thus have an incentive to

increase the firm’s overall risk, which leads to a higher cost of equity capital.

Our empirical findings offer several new insights. First, we show that firms with

higher CEO compensation portfolio deltas are associated with a significantly lower

implied cost of equity capital while firms with higher CEO compensation portfolio

vegas are associated with a significantly higher implied cost of equity capital. The

lower implied cost of equity capital among high CEO compensation portfolio delta

firms and the higher implied cost of equity capital among high CEO compensation

portfolio vega firms are observed consistently across all individual measures of the

implied cost of equity capital as well as the average-based measure of the implied

cost of equity capital. For the average-based measure of the implied cost of equity

capital, the effect of CEO compensation portfolio deltas on the cost of equity capital is

a reduction of 60 basis points going from the 25th percentile to the 75th percentile of

CEO compensation portfolio deltas. The effect of CEO compensation portfolio vegas

on the average-based measure of the implied cost of equity capital is somewhat smaller,

with an increase of 16 basis points going from the 25th percentile to the 75th percentile

of CEO compensation portfolio vegas.3Our empirical findings remain robust when we

address endogeneity concerns by adopting a two-stage instrumental variable approach

to investigate the relationship between executive compensation portfolio sensitivities

and the cost of equity capital. Our findings also remain robust to changes-in-variables

regression analysis, top five executives deltas and vegas, and decomposition of deltas into

stock deltas and option deltas.

Our findings are further robust in a natural experiment when we examine the

change in the cost of equity capital for a group of firms that started to voluntarily

expense stock options in 2002 and 2003 (Elayan et al., 2005). The implementation

of stock options expensing represents a change in the accounting treatment of stock

options and is plausibly not related to the link between the usage of stock options

and managerial incentives. Carter et al. (2007) show that firms reduce the use of

stock options and increase the use of restricted stocks after they start expensing

stock options while there is no reduction in the overall CEO compensation.4We fin d

that the compensation restructure arising from stock options expensing leads to a

decrease in CEO compensation portfolio vegas and an increase in CEO compensation

portfolio deltas, hence an overall decrease in risk incentive. Consistent with the positive

relationship between cost of capital and risk incentive, we find that firms expensing

3 These results are consistent with Prevost et al. (2013) who document that the delta effect is valued more

highly than the vega effect in the cross-section of corporate yield spread.

4 Carter et al. (2007) assert that the shift into restricted stock following these firms’ decisions to expense

options is consistent with the argument that favorable accounting treatment for options in the pre-expensing

regime might have led to an overweighting of options in executive pay packages. Hence, the compensation

restructure is strongly associated with a proxy for accounting costs.

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