Financing Decisions When Managers Are Risk Averse
Name
4438-03.pdf
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418.62 KB
Format
Adobe PDF
Checksum (MD5)
72d67c8c86bf2ce0499610f46c9855c0
Author(s)
Lewellen, Katharina
Date Issued
February 6, 2004
Series/Report no.
MIT Sloan School of Management Working Paper;4438-03
Abstract
This paper studies the impact of financing decisions on
risk-averse managers. Leverage raises stock volatility, driving a wedge between the cost of debt to shareholders and the cost to undiversified, risk-averse managers. I quantify these "volatility costs" of debt and examine their impact on financing decisions. The paper finds: (1) the volatility costs of debt can be large, particularly if the CEO owns in-the-money options; (2) higher option ownership tends to increase, not decrease, the volatility costs of debt; (3) a stock price increase typically reduces managerial preference for leverage, consistent with prior evidence on security issues. Empirically, I estimate the volatility costs of debt for a large sample of U.S. firms and test whether these costs affect financing decisions. I find evidence that volatility costs affect both the level of and short-term changes in debt. Further, a probit model of security issues suggests that managerial preferences help explain a firm's choice between debt and equity
Subjects
Executive Compensation
Stock Options
Risk Incentives
Leverage
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