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Bank of Finland Research Discussion Papers, Bank of Finland

No 19/2011:
Leverage and growth: effect of stock options

Bill Francis, Iftekhar Hasan () and Zenu Sharma

Abstract: This paper investigates the potential effects of stock options on managersí investment decisions and therefore on a firmís 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 firmís 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 managerís 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 firmís growth and finds that leverage is negatively related to growth only in poorly governed firms.

Keywords: leverage; stock options; compensation schemes; corporate governance; (follow links to similar papers)

JEL-Codes: C21; G32; G34; (follow links to similar papers)

58 pages, October 5, 2011

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