Optimal Inside Debt Compensation and the Value of Equity and Debt

We use firm and chief executive officer (CEO) characteristics motivated by optimal contracting theory to estimate optimal CEO relative debt-equity incentive ratios. Equity values rise as firms adjust CEO incentive ratios toward their predicted optimums, whether that increases or decreases the relative incentive ratio. Debt values rise as firms adjust ratios upward and do not fall as they adjust them downward. Our predicted optimums explain changes in equity and debt values better than a model in which firms simply match CEO inside debt-equity ratios to firm debt-equity ratios. The results suggest important cross-sectional differences in firms’ optimal inside debt policies.