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The Impact Of Inside Debt On Firm Value Finance Essay

Economists have identified inside debt as representing fixed obligations pertaining to a particular organization which are used for making future payments to corporate insiders (Wei and Yermack, 2011).The term inside debt can be used interchangeably with deferred compensation; this type of payment to top executives is not a new concept, although research on this topic has been limited, prior to 2006 because of firms non-disclosure policies towards executive compensation. Inside debt comes in various forms; one of which is pensions received by executives and the other form is mandatory or voluntary schemes where they hold off receipt of annual salary and bonus pay, allowing the money to be rolled over within the firm with a certain rate of return until their retirement (Wei and Yermack, 2010).

Edmans and Liu (2010) have also inferred that inside debt is a better resolution to the problem of agency costs of debt rather than the solvency-contingent bonuses and salaries as propounded by earlier articles. This is because a firm’s value in bankruptcy as well as its incidence is considered. This notion is seconded by Wei and Yermack (2011) as they believe inside debt has the potential to reduce the agency costs of debt in a levered firm.

Furthermore, as a result of the global financial crisis that began between 2007 and 2008, there is an increased discourse that advocates for the increased use of deferred compensation in the remuneration of top executives. This idea arises from the belief that equity incentives such as stock options etc will encourage high level of risk taking among top executives, especially those in the financial sector as this sector was most affected by the economic crisis (Wei and Yermack , 2010);(Wei and Yermack ,2011).

The context of inside debt in relation to executive pay.

The issue of top management or executive pay has been under debate for many years, authors such as Jensen and Meckling (1976) have described the agency problem to mean that of aligning managerial power and discretion to that of shareholder value.

The agency costs that arise from debt is as a result of methods by which top executives manoeuvre the firm’s investment policies and capital structure in order to redistribute its wealth from the hands of the debt-holder to that of the shareholder which usually results in an increase in risk for the firm Wei and Yermack (2010,2011).

Authors such as Jensen and Meckling (1976) have advocated the creation of an ideal incentive structure in which the ratio of the manager’s personal ownership of the firm’s debt and equity mimics that of the firm’s capital structure overall. This is because it has been found that when a top executive’s inside debt holdings is greater than the situation described above, the executive tends to act too conservatively and subsequently runs the company in a similar manner. This results in reduction in overall risk taking and the transfer of wealth from the shareholders to debt holders.

Other problems of purpose alignment may also arise as noted by Shleifer and Vishny (1997) who believe that executives look out for their private interest which may not be in line with those of shareholders. Jensen (1986) is also of the opinion that mangers will like to indulge in empire building, this view is also shared by Baumol (1967) and Marris (1963) who assert that CEOs pursue growth of the company rather than profitability due to the prestige and reputation ascribed to running a large organisation. In order to combat this problem of clashing interests Brickley et al (2009) are of the view that performance-based compensation which entails performance based bonuses, stock options, pensions etc can be used to align the interests of both the executive and shareholders.

Sundaram and Yermarck (2007) also note that firms which have executives’ with large inside debt holdings tend to experience a reduced probability of the organisation defaulting on external debt, this is consistent with the theory that these executives run the company with a conservative outlook to debt values. Tung and Wang (2010) also agree with this theory and believe that CEOs with large amounts of inside debt compensation tend to reduce the exposure of their firms to risk and performed better as a result during the economic recession.

Majority of firms have obligations of inside debt to their mangers, these debts are unsecured and unfunded and therefore expose the mangers to risks of default leaving them to struggle with outside creditors for remuneration in the advent of bankruptcy Wei and Yermack (2010, 2011).

There are however some draw backs to this incentive plan, the possibility exists that in situations where CEOs have prior knowledge of company descent into bankruptcy, they will opt for early retirement with collection of their pension in lump sum amounts, thereby reducing the firm’s liquidity and further aiding its descent into bankruptcy (Wei and Yermack, 2011). Also Anantharaman et al (2011) believes that instead of combating agency costs, debt-like compensation will connect managerial concerns and interests to those of debt holders and not share holders.

The impact of inside debt to firm’s value

Prior to 2007 there has been no documented evidence of the impact of inside debt due to lack of disclosure of the value of inside debt and executive compensations by firms, however this has changed due to the revision of SEC executive compensation disclosures rules in 2006 with an increased emphasis on transparency of inside debt and deferred compensation values (Wei and Yermack, 2010). This transparency has provided investors with insight into the compensation packages of the various CEOs running the companies they are investing in or intend to invest in and has been seen to have an effect on firm value. A study by Wei and Yermack (2011) observed that in situations where companies revealed CEOs with high levels of inside debt, investors tend to have valuation changes that reflect in corporate bond prices and share prices. As a result of their research, they came to the conclusion that investors react adversely especially in a situation where a CEO has substantial inside debt in relation to his investment in the firm.

The attending effect is that of a reduction in the value of the firm in totality, which results in increased benefit for bondholders and corresponding loss to shareholders. Other effects include a fall in the volatility of stocks as well as bonds with the revealing of CEO inside debt positions (Wei and Yermack, 2011). Wei and Yermack (2010) stated that there is evidence of a transfer of value towards debt from equity with a reduction of the firm’s risk and destruction of its value. Wei and Yermack (2011) also posed an alternative explanation as to why shareholders react negatively to large inside debt and this is that shareholder’s perceiving large deferred compensation packages as deadweight loss to the firm.

However a study by DeFusco et al (1990) revealed opposite findings. This classic study was one of the few papers that researched this phenomenon before SEC laws were changed in 2006. The paper studies the effect of revealing the executive stock option plans introduced by more than 400 firms between 1978 and 1982. It was observed that the stock prices of firms rose and bond prices fell over this period. Also observed was an increase in the volatility of equity at the time of planned disclosure. Defusco et al (1990) translated these results to correspond to the risk shifting pattern in which both debt and equity investors expected firms to invest in riskier strategies due to the top executive’s option–based incentive compensation.

Conclusion.

We can conclude therefore that inside debt is an important phenomenon in the compensation of top executives in any organisation. The concept has some merits and can be seen to be beneficial in aligning management’s interests with those of shareholders. However, every solution cannot be absolute and the greatest disadvantage of this concept is the tendency to make executives conservative in their management of the firm which results in a reduction in shareholder value.

Inside debt has also been seen to have an effect on the value of the firm. Recent research has shown that high level of inside debt has a negative impact on a firm’s value. Firms need to pay attention to this point and work to align manager’s personal ownership of the firm’s debt and equity to mimic that of the firm’s capital structure. Finally one can infer that executive compensation should be revised occasionally in other to ensure that the aims of the executive are aligned to the appropriate bodies and that incentive plans should be tailored as such to achieve the desired outcome.

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