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Leverage and growth: effect of stock options

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Author Info

  • Francis, Bill

    (Lally School of Management, Rensselaer Polytechnic Institute)

  • Hasan , Iftekhar

    ()
    (Lally School of Management, Rensselaer Polytechnic Institute, and Bank of Finland)

  • Sharma, Zenu

    (Long Island University)

Abstract

This paper investigates the potential effects of stock options on managers’ investment decisions and therefore on a firm’s growth or, alternatively, on its leverage-growth relationship. To structure the analysis addressing this issue, the paper utilizes a framework establishing a negative relationship between leverage and the firm’s growth. However, in contrast to some of the existing results, the empirical analysis of manufacturing firms in this paper shows that the negative relationship between leverage and growth has changed significantly. Primarily this paper documents that, as options based compensation in manager’s portfolio increases, the negative effect of leverage on growth disappears. The paper argues that this is an important finding, because it implies that when managers are compensated with options debt ceases to pre-commit managers. On addressing the potential endogeneity problem between leverage, growth and compensation the paper finds that option delta instead of book leverage negatively affects growth, and that book leverage and option delta are inversely related. Finally, the paper also examines the effect of corporate governance on the relationship between leverage, incentives and the firm’s growth and finds that leverage is negatively related to growth only in poorly governed firms.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/BoF_DP_1119.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 19/2011.

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Length: 58 pages
Date of creation: 05 Oct 2011
Date of revision:
Handle: RePEc:hhs:bofrdp:2011_019

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: leverage; stock options; compensation schemes; corporate governance;

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