Managerial risk incentives and a firm's financing policy

Abstract

This paper provides a theoretical explanation for how risk preferences of a firm’s manager impact a firm’s optimal financing policy and shareholder value. The developed model implies that firms in growing industries are more valuable if they are run by more risk-seeking managers. Similarly, firms operating in declining industries should be run by less risk-seeking managers. Given that a firm’s optimal assets do not depend on the growth opportunities, and that debt is the difference between assets and equity, the model implies that there is a negative (positive) correlation between the riskiness of CEOs’ compensation packages and firms’ financial leverage ratios for firms in growing (declining) industries. This prediction is in stark contrast to economic intuition and prior literature in that less risk aversion normally should increase risk-taking. The empirical analysis generally supports all the model’s implications except those related to firms operating in declining industries.