Leverage, executive incentives and corporate governance

This paper analyses the effect of executive incentives and internal governance on capital structure. Using a large sample of non-financial US-listed firms over the period 1999-2005, it is found that managers have different attitudes towards leverage when offered different incentive schemes; leverage initially decreases in bonuses and stock incentives and then increases in these incentives after a certain incentive level, suggesting the existence of the entrenchment-alignment effects under these incentive schemes. In contrast, leverage initially increases in option incentives and then decreases after a certain option incentive level. When all of these incentive schemes are combined together into a single incentive package, the entrenchment-alignment effects prevail. It is also found that leverage increases in internal governance and managers behave differently under different governance regimes such that the entrenchment-alignment effects prevail under weak governance firms, whereas the alignment-entrenchment effects prevail under strong governance firms. The results also suggest that managers' target leverage ratio is less than the one predicted by theory or preferred by firm shareholders.