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 19992005, 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 entrenchmentalignment 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 entrenchmentalignment effects prevail. It is also found that leverage increases in internal governance and managers behave differently under different governance regimes such that the entrenchmentalignment effects prevail under weak governance firms, whereas the alignmententrenchment 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.