Inside Debt, Financing Constraints, and Corporate Investment

• In Event: Incentives and Performance Evaluation

Abstract

Prior literature has examined the role of inside debt in dampening CEO risk-taking incentives, and several recent studies have documented a negative association between CEO inside debt holdings and firm investment in R&D. In this paper, we examine whether inside debt, by providing greater alignment of CEOs’ incentives with debtholders’, can increase the supply of debt financing and therefore increase investment levels. In contrast to the simple negative relationship documented in prior research, we hypothesize and find that the relationship between inside debt and R&D investment levels depends on the degree of financing constraints facing the firm. In particular, we find that when financing constraints are low, the relationship between inside debt and R&D investment is negative, consistent with the findings of prior research. However, we find a significant positive association between inside debt and R&D levels for firms facing financing constraints. Our findings contribute to the literature on CEO incentives and corporate investment policy, and provide a richer understanding of the role of debt-like compensation in reducing agency costs.

Authors

• Joonil Lee, Kyung Hee University

• Kevin J. Murphy, University of Southern California

• Peter Oh, University of Southern California

• Marshall Vance, University of Southern California