Financing Decisions When Managers Are Risk Averse

Katharina Lewellen

No 4438-03, Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management

Abstract: This paper studies the impact of financing decisions on risk-averse managers. Leverage raises stock volatility, driving a wedge between the cost of debt to shareholders and the cost to undiversified, risk-averse managers. I quantify these "volatility costs" of debt and examine their impact on financing decisions. The paper finds: (1) the volatility costs of debt can be large, particularly if the CEO owns in-the-money options; (2) higher option ownership tends to increase, not decrease, the volatility costs of debt; (3) a stock price increase typically reduces managerial preference for leverage, consistent with prior evidence on security issues. Empirically, I estimate the volatility costs of debt for a large sample of U.S. firms and test whether these costs affect financing decisions. I find evidence that volatility costs affect both the level of and short-term changes in debt. Further, a probit model of security issues suggests that managerial preferences help explain a firm's choice between debt and equity

Keywords: Executive Compensation; Stock Options; Risk Incentives; Leverage (search for similar items in EconPapers)
Date: 2004-02-06
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Citations: View citations in EconPapers (1)

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