Journal of Banking & Finance 34 (2010) 2518–2529

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Journal of Banking & Finance

journal homepage: www.elsevier.com/locate/jbf

Do executive stock options induce excessive risk taking? q

Zhiyong Dong a,* , Cong Wang b, Fei Xie c
a
School of Economics, Peking University, Beijing, China
b
Faculty of Business Administration, Chinese University of Hong Kong, Hong Kong, SAR, China
c
School of Management, George Mason University, Fairfax, Virginia, United States

a r t i c l e i n f o a b s t r a c t

Article history: We examine whether executive stock options can induce excessive risk taking by managers in firms’
Received 1 January 2009 security issue decisions. We find that CEOs whose wealth is more sensitive to stock return volatility
Accepted 19 April 2010 due to their option holdings are more likely to choose debt over equity as a capital-raising vehicle. More
Available online 7 May 2010
importantly, the pattern holds not only in firms that are underlevered relative to their optimal capital
structure but also in overlevered firms. This evidence is inconsistent with executive stock options align-
JEL classification: ing the interests of managers and shareholders; rather, it supports the hypothesis that stock options
G30
sometimes make managers take on too much risk and in the process pursue suboptimal capital structure
G32
policies.
Keywords: Ó 2010 Published by Elsevier B.V.
Executive stock options
Excessive risk taking
Capital structure
Securities offerings

1. Introduction regulators hold stock options at least partially accountable for

The 1990s witnessed an explosion in the use of restricted stock
and stock options in executive pay packages (Murphy, 1999), and
equity-based pay has represented a significant proportion of execu-
tive compensation ever since. One of the widely accepted economic
justifications for this phenomenon is that equity ownership can
potentially align the interests between managers and shareholders
and thus mitigate the agency problems due to the separation of
ownership and control characterizing large public corporations
(Berle and Means, 1933; Jensen and Meckling, 1976).
However, greater equity ownership does not always lead to
better managerial decisions and higher shareholder value. Large
shareholdings may enable managers to effectively block control
contests, become entrenched, and extract private benefits at the
expense of shareholders (Morck et al., 1988; Stulz, 1988;
McConnell and Servaes, 1990). Managers with significant stock
and stock option ownership may also develop symptoms of mana-
gerial myopia and display certain perverse behaviors that are
detrimental to shareholders. For example, the popular press and
q
We thank an anonymous referee for helpful comments that significantly
improved the paper.
* Corresponding author. Tel.: +86 10 6275 9760; fax: +86 10 6275 1462.
E-mail addresses: dzy@pku.edu.cn (Z. Dong), congwang@baf.msmail.cuhk.edu.hk
(C. Wang), fxie@gmu.edu (F. Xie).
some of the high-profile corporate scandals early this decade. Aca-
demic studies emerge with evidence that stock and especially
stock option holdings induce managers to manipulate corporate
earnings and commit accounting fraud to boost market valuations
and enrich themselves by selling shares or exercising options at in-
flated stock prices (Cheng and Warfield, 2005; Bergstresser and
Philippon, 2006; Burns and Kedia, 2006, 2008; Peng and Roell,
2008). Recent research has also uncovered rather widespread back-
dating of executive stock options by companies (Lie, 2005; Heron
and Lie, 2007, 2009; Narayanan and Seyhun, 2008). This practice
benefits executives receiving options and when exposed, causes
tremendous damage to shareholder wealth (Narayanan et al.,
2007; Bernile and Jarrell, 2009).1
In this paper, we examine another potential concern about the
incentives provided by stock and stock options, namely, whether
they induce risk taking by managers beyond the level desirable
for shareholders. It is well recognized that unlike diversified
shareholders, managers are risk averse because of their organiza-
tion-specific human capital and undiversified wealth portfolios
(Amihud and Lev, 1981). As a result, they may forego risky but
positive net present value (NPV) projects. To address this problem,
firms resort to stock options and their convex payoff structure to
1
See, e.g., Mangiero (2007) for an in-depth discussion of option related scandals.

0378-4266/$ - see front matter Ó 2010 Published by Elsevier B.V.

doi:10.1016/j.jbankfin.2010.04.010
 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529
encourage managers to take more risk.2 Many studies provide evi-
dence that managers do appear to respond to such incentives
(Guay, 1999; Cohen et al., 2000; Knopf et al., 2002; Rajgopal and
Shevlin, 2002; Chen et al., 2006; Coles et al., 2006; Brockman
et al., 2009). However, what is left unaddressed is whether the in-
duced risk taking by managers is beyond the optimal level.
Lambert (1986), Ju et al. (2003), and Raviv and Landskroner
(2009) all show theoretically that under call option like contracts
managers can take too much risk. This seems consistent with pop-
ular claims that companies where managers receive significant
stock option compensation tend to borrow too much, a problem
that hastened the demise of Enron in 2001,3 and that the compen-
sation system at financial institutions was a contributing factor to
the financial crisis of 2007–2009 by encouraging excessive risk tak-
ing and overleveraging.4
Despite the immediate relevance of the issue, systematic evi-
dence on whether managerial equity incentives lead to undue risk
taking is scarce, mainly because it is difficult to establish how
much risk is too much. To overcome this obstacle, we examine
the effect of equity-based compensation on managerial risk taking
in the context of firms’ choices between debt and equity in security
issue decisions. Corporate capital structure policies provide an
ideal setting for our investigation since there is a well developed
literature on optimal or target capital structure,5 which can help
us identify what managerial actions represent risk taking beyond
the optimal level.
Our analysis of 3734 security offerings by US public companies
from 1993 to 2007 shows that managers are more likely to use
debt than equity as a capital-raising vehicle when their wealth is
more sensitive to stock return volatility, i.e., when they have a
higher vega. This result is intuitive, since compared to equity
financing, debt financing increases firm leverage and stock return
volatility, and thus managers with a higher vega stand to gain more
from a debt issue. We also find that managerial wealth sensitivity
to stock price, i.e., delta, does not affect corporate financing deci-
sions. Together, these two findings suggest that it is the stock op-
tion holdings instead of stock ownership that play a role in shaping
managerial preference between debt and equity, since vega comes
entirely from stock options while both stock and stock options con-
tribute to delta.6
To see whether the preference of high-vega CEOs for debt re-
flects excessive risk taking, we follow the approach of Hovakimian
et al. (2001) and separate firms into those that appear underle-
vered relative to their optimal leverage ratios and those that ap-
pear overlevered. We repeat our analysis of security issue
decisions in the two subsamples, and find that CEOs with a higher
vega are more likely to eschew equity and choose debt in both
subsamples. While the evidence from the underlevered subsample
is consistent with the argument in Berger et al. (1997) that stock
2
The theoretical literature on this issue is unsettled; whether stock options can
induce more risk taking depends on characteristics of options (moneyness) and the
utility function, risk aversion, and outside wealth of managers (see, e.g., Lambert
et al., 1991; Carpenter, 2000; Ju et al., 2003; Ross, 2004; Tian, 2004; Braido and
Ferreira, 2006).
3
See ‘‘The fall of Enron”, Business Week, December 17, 2001.
4
See ‘‘In times of tumult, obscure economist gains currency”, Wall Street Journal,
August 18, 2007, and ‘‘The Minsky moment”, The New Yorker, February 4, 2008.
5
Harvey and Graham (2001) also present survey-based evidence that most firms
have an optimal or target debt-to-equity ratio.
6 ness checks. Section 5 concludes.
Strictly speaking, stock holdings contribute to vega as well, since stock can be
considered as a call option written on total firm value and its value rises with firm
risk. However, Guay (1999) shows that a stock’s value sensitivity to firm risk is several
orders of magnitude smaller than that of a stock option. The reason is that when
considered as a call option written on total firm value, stock is deep in the money for
most companies, and deep-in-the-money options have little sensitivity to volatility.
Therefore, as is customary in the literature (see, e.g., Knopf et al., 2002; Rajgopal and
Shevlin, 2002; Coles et al., 2006; Cunat and Guadalupe, 2009; Sun et al., 2009), we
estimate vega from stock options only.
2519
option ownership aligns the interests of managers and sharehold-
ers and better-aligned managers increase leverage toward an opti-
mal level, our finding of high-vega CEOs favoring debt financing
even in overlevered firms is difficult for the incentive alignment-
based hypothesis to explain. Instead, it supports the hypothesis
that managers choose to issue debt rather than equity to maximize
the value of their option portfolio even if doing so causes firms to
deviate further from their optimal leverage and is not in the best
interests of shareholders.
In light of the finding by Lemmon et al. (2008) that there is an
unidentified time-invariant determinant of firms’ capital structure,
we augment our optimal-leverage model by including firm fixed
effects. We classify security issuers in our sample into overlevered
and underlevered based on the prediction of the modified leverage
model, and continue to observe high-vega CEOs preferring debt
over equity in the overlevered subsample.
We also extend our analysis to examine how the overall change
in a firm’s leverage is related to CEO vega and uncover evidence
consistent with our security issue decision analysis. More specifi-
cally, CEOs with a higher vega are more aggressive in increasing
leverage, even at firms that appear already overlevered compared
to their optimal debt ratios.
Our study makes three contributions to the literature. First, we
identify excessive risk taking as another unintended adverse con-
sequence of giving large stock option grants to top executives, in
addition to creating incentives to manage earnings, commit finan-
cial fraud, and manipulate the timing of grants. More specifically,
we find that CEOs with a high vega from their stock option hold-
ings sometimes pursue suboptimal capital structure policies by
overleveraging their companies in order to increase the value of
their stock option portfolios. Our evidence suggests that there
may be merits in the call for and the practice of companies replac-
ing executive stock options with restricted stock.7
Second, we add a new dimension to the agency theory proposed
by Jung et al. (1996), who show that managerial discretion and pri-
vate benefits play an important role in firms’ financing decisions. In
our analysis, the potential value appreciation of executive stock
options due to higher risk can be considered as a private benefit,
which induces managers to take on excessive risk by shunning
equity and choosing debt despite the fact that their firms are over-
levered. Ironically, stock options, originally put in place by boards
to align the interest of managers and shareholders, are the source
of the agency conflict here.
Third, we extend the literature on the effect of stock options on
managerial risk taking. Previous studies find that managers re-
spond to stock option compensation by adopting riskier financial,
investment, and hedging policies. We advance these findings one
step further by showing that stock options sometimes drive man-
agers to engage in excessive risk taking.
The remainder of the paper is organized as follows. Section 2
describes the sample and variable construction for the probit anal-
ysis of security issue decisions. Section 3 presents the results from
the probit analysis in both the full sample and the overlevered and
underlevered subsamples. Section 4 presents the results from (i)
augmenting the optimal-leverage model by firm fixed effects, (ii)
including preferred equity and convertible debt offerings as
additional financing choices, (iii) examining the relation between
overall leverage changes and CEO vega, and (iv) a variety of robust-
7
In 2001, stock option grants accounted on average for 44% of total CEO
compensation. By 2005, the percentage had dropped to 28%. During the same period,
the average percentage of equity-based pay including restricted stock and stock
options in total CEO compensation only decreased from 49% to 42%. Perhaps the most
notable example of this trend is Microsoft, which, in July 2003, announced that it
would replace all future stock option grants with restricted stocks.
2520 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529

2. Sample and variable construction Table 1

Distributions of security offerings by issue year and issuer industry.

2.1. Sample construction Year # of equity offerings # of debt offerings

Panel A: Issue year breakdown
We extract from the SDC New Issues Database all common 1993 82 220
equity and straight debt offerings by US public companies during 1994 53 144
1995 60 240
the period from 1993 to 2007.8 We exclude offerings by issuers
1996 60 257
who (i) are in the utility (two-digit SIC code: 49), financial (one-di- 1997 61 263
git SIC code: 6), and public administration (one-digit SIC code: 9) 1998 46 357
industries, (ii) do not have complete financial and stock price data 1999 83 223
available from COMPUSTAT and CRSP, (iii) do not have executive 2000 82 172
2001 52 237
compensation data available in Standard & Poor’s ExecuComp
2002 47 223
database, or (iv) offered both equity and debt during the same fis- 2003 44 153
cal year.9 We also delete purely secondary stock offerings from our 2004 69 93
sample since they do not bring any new funds into the issuing 2005 37 75
2006 28 111
firms and thus do not change the firms’ financial position. Our final
2007 21 141
sample consists of 825 common stock offerings and 2909 straight
Total 825 2909
debt offerings.10 Panels A and B of Table 1 present the issue year
and issuer industry distributions for the equity and debt offerings. Industry description 2-digit SICs # of equity # of debt
offerings offerings
In our sample, debt offerings are much more common than equity
offerings, a pattern that is also observed by other studies (e.g., Panel B: Issuer industry breakdown based on 2-digit SIC codes
Agriculture, forestry, and fisheries 01–09 1 8
Hovakimian et al. (2001)). There is no obvious concentration of
Mineral industries 10–14 82 119
debt or equity issues in any year, with years 1993, 1999 and Construction industries 15–17 5 99
2000 having relatively more stock offerings and years 1996–1998 Manufacturing industries 20–39 424 1531
having relatively more bond issues. Based on two-digit SIC codes, Transportation and communication 40–48 46 431
over 50 industries are represented in our sample. About 50% of Wholesale trade 50–51 39 121
Retail trade 52–59 65 330
debt offerings and stock offerings are by firms in the manufactur-
Service industries 70–89 163 270
ing industries (SIC codes: 2000-3999).
Total 825 2909

2.2. Variable construction The sample consists of 825 seasoned common equity offerings and 2909 straight
debt offerings during the period 1993–2007. We exclude offerings by issuers who
(i) are in the utility, finance, and public administration sectors, (ii) do not have
Our model of firms’ security issue decisions closely resembles necessary financial statement and stock return data available from COMPUSTAT
that of Jung et al. (1996) and includes a set of standard explanatory and CRSP, (iii) do not have executive compensation information from the Standard
variables drawn from the literature. We augment the model by & Poor’s ExecuComp database, or (iv) issue both equity and debt during a single
fiscal year. Purely secondary stock offerings are also removed.
adding CEO delta and vega as two additional explanatory variables.
Delta measures the sensitivity of a CEO’s wealth to stock price and
by 1% when the stock price changes by 1%.12 We estimate CEO del-
is computed as the change in dollar value of the CEO’s entire stock
ta and vega from stock options by following the algorithm devel-
and stock option portfolio per 1% increase in her firm’s stock price.
oped by Core and Guay (2002). A CEO’s overall delta is thus
Vega measures the sensitivity of the CEO’s wealth to stock return
equal to the delta from her stock ownership plus the delta from
volatility and is computed as the change in dollar value of the
her stock option ownership, while the CEO’s vega comes solely
CEO’s entire stock and stock option portfolio per 1% increase in
from her stock option ownership. Appendix A describes our delta
her firm’s annualized stock return volatility. There is anecdotal evi-
and vega estimation procedure in detail.
dence that top executives other than CEOs, e.g., Chief Financial
Our model controls for a wide array of potential determinants of
Officers (CFO), can also exert influence on firms’ financing policy.
firms’ debt-equity choice, including macroeconomic conditions
Therefore, rather than focusing exclusively on CEO equity incen-
and issuer characteristics such as firm size, tax status, Tobin’s Q,
tives, we also try to take full advantage of each firm’s information
profitability, leverage, asset tangibility, refinancing needs, stock re-
from ExecuComp, which details the top five highest paid officers’
turn volatility, and recent stock price runup. These variables are
compensation and equity and stock option holdings. From this
widely used in the empirical literature of capital structure to cap-
information, we construct the aggregate delta and vega for each
ture the potential tax savings from debt financing, the expected
firm’s top management team. Using these aggregate equity incen-
cost of financial distress, and the degree of information asymmetry
tive measures yields qualitatively similar results.11
faced by issuing firms.
We treat stock and stock options separately when calculating
Because of the tax deductibility of interest payments, the attrac-
CEO delta and vega. CEO delta from common and restricted stock
tiveness of debt financing relative to equity financing increases
holdings is easy to compute, because the value of stock changes
with a firm’s marginal tax rate. Following Jung et al. (1996), we
8
measure a firm’s potential tax savings from having more debt in
We end our sample period prior to the 2008 freeze-up of the global credit market
due to the financial crisis.
its capital structure by the ratio of tax payments divided by the
9
This last restriction is put in place in order to avoid cases where a firm is classified book value of total assets for the year prior to each security issue.
as both an equity issuer and a debt issuer in a given year. Using Graham’s (1996) marginal tax rate estimates as an alterna-
10
It is not unusual that a firm conducts several debt offerings on a single day but in tive has no material impact on our results. We expect firms with
different amounts and under different terms. The SDC records each of the offerings as
higher tax rates to be more likely to issue debt than equity, since
a separate transaction. In order to reduce the cross-sectional dependency of the
observations and avoid artificially inflating the statistical significance of the
12
coefficient estimates, we combine these offerings into a single issue in our regression Strictly speaking, the value of restricted stocks changes by less than 1% when the
analysis. Our results are qualitatively the same and statistically stronger if we treat stock price changes by 1%, since they are not as readily tradable as the CEO’s common
each of the offerings as an independent observation. equity holdings. Unfortunately, the literature has not come up with a method to
11
Our results are also robust to using the average delta and vega for each firm’s address this concern, and we believe the resulting deviation to be minor and
management team. inconsequential.
 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529
the higher the corporate tax rates, the more likely the corporate tax
shield from added debt service will be fully utilized, and the more
valuable the tax shield.
Despite the potential tax savings, more debt will increase the
probability and expected cost of financial distress. If a firm already
has a high probability of financial distress prior to a security issue,
the expected cost of debt issuance may outweigh the expected
benefit, making debt financing less desirable than equity financing.
We employ three proxies for a firm’s probability of financial dis-
tress. The first measure is the market leverage ratio, which is equal
to the book value of long-term debt and short-term debt divided by
the market value of total assets, where the market value of assets is
equal to the book value of assets minus the book value of common
equity plus the market value of common equity; the second mea-
sure is the monthly stock return volatility estimated over the past
60 months prior to a security offering; and the third measure is
firm profitability proxied by the return on assets (ROA), i.e., earn-
ings before interest, tax, depreciation and amortization (EBITDA)
divided by the book value of total assets, for the year prior to the
issue.
Information asymmetry surrounding an issuing firm also affects
the firm’s choice between debt and equity financing, since it makes
equity issuance more expensive (Myers and Majluf, 1984). There-
fore, Korajczyk et al. (1991) argue that firms should time their
equity issues for periods when the information asymmetry is less
severe. Along the lines of Lucas and McDonald (1990), we proxy
for an issuing firm’s information asymmetry by its net-of-market
stock return over the year prior to an offering and its market-to-
book ratio (as a proxy for Tobin’s Q) at the end of the previous year.
Both measures are inversely related to information asymmetry.
Following Choe et al. (1993) and Jung et al. (1996), we also include
in our regression the 6-month growth rate in the leading indicator
as a gauge of macroeconomic conditions, since there may be less
information asymmetry when the economy is in expansion than
when it is in recession.
The Myers and Majluf model also implies that firms with more
assets in place are associated with less information asymmetry and
thus are more likely to issue equity. We measure assets in place by
the asset tangibility ratio, calculated as the net book value of plant,
property and equipment (PPE) over the book value of total assets.
We expect it to be negatively associated with the degree of infor-
mation asymmetry and thus to raise the probability of issuing
equity. However, a higher asset tangibility ratio also implies that
a firm has more debt capacity because of the collaterability of tan-
gible assets and as a result, is more able or likely to issue debt.
Therefore, the net impact of asset tangibility on firms’ debt-equity
choice is ambiguous.
We also control for firm size, which is equal to the logarithmic
transformation of the book value of assets denominated in million
dollars. Firm size affects the costs of financial distress as well as
information asymmetry. Larger firms tend to have diversified rev-
enue streams and thus are less likely to succumb to negative
shocks specific to certain sectors. Larger companies are associated
with less information asymmetry since they are subject to more
public scrutiny and have more analyst coverage. However, it is also
possible that larger firms have more complex operations that out-
siders find difficult to decipher, resulting in a higher degree of
information asymmetry.
Since firms often issue bonds to replace debt that is coming due
soon, usually within a year, we use the ratio of long-term debt due
in one year to the book value of total assets to capture a firm’s refi-
nancing needs and predict that firms with greater refinancing
needs are more likely to issue new debt.
Finally, we control for the relative size of a security offering
measured by issue proceeds normalized by the book value of total
assets. There is some concern that issue size may be endogenously
2521
determined, just as the type of security in the offering. Therefore,
the relative issue size can not be used by investors to forecast a
firm’s debt-equity choice since ex ante investors generally have lit-
tle knowledge about how much capital the firm is going to raise.
However, for our purpose, regressions with the relative issue size
as an independent variable are desirable since our objective is to
explain managers’ decision regarding which security to offer.13 It
is not clear ex ante whether firms in need of a substantial amount
of capital will choose to issue equity or debt. They could choose
equity if they have very limited untapped debt capacity or choose
debt if they worry about the ownership dilution effect of large
equity offerings. We also include calendar year and industry (based
on two-digit SIC codes) fixed effects to capture any time- or sector-
invariant factors that influence firms’ security issue decisions.14 All
explanatory variables except relative issue size are measured be-
fore security offerings. Appendix B contains the definitions of all
the aforementioned variables.
3. Analysis of security issue decisions
3.1. Univariate analysis
Table 2 presents summary statistics for all explanatory variables
in the model of security issue decisions for the full sample as well as
the debt issue and equity issue subsamples. A comparison of the
two subsamples indicates that debt-issuing firms and equity-issu-
ing firms differ in many dimensions. Specifically, equity issuers tend
to have a higher Tobin’s Q, stock return volatility and recent stock
price runup, while debt issuers tend to be larger and more profit-
able, pay more tax, and have more tangible assets and greater refi-
nancing needs. In addition, proceeds from equity issues are lower in
absolute terms, but higher in relative terms, and equity issues are
more likely to coincide with favorable macroeconomic conditions.
More importantly, we find that CEO vega is significantly higher
at debt issuers than at equity issuers, consistent with our hypoth-
esis that CEOs whose wealth is more sensitive to stock return vol-
atility tend to favor debt over equity.15 The univariate analysis,
however, is only suggestive and does not provide us with reliable
inferences. For example, Baker and Hall (2004) show that CEOs at
larger firms often have higher levels of equity incentives, and our
data indicate that larger firms are more likely to issue debt. These
relations imply that the positive correlation between CEO vega and
the probability of firms issuing debt could be spurious. In the next
section, we therefore turn our attention to multivariate probit
regression analyses.
3.2. Probit analysis
Our probit model of firms’ security issue decisions is specified
as follows:
Probability ðy ¼ 1Þ ¼ Uða0 þ a1 logð1 þ vegaÞ þ a2 logð1 þ deltaÞ
þ a3 logðtotal assetsÞ þ a4 tax status
0
þ a5 Tobin s Q þ a6 ROA þ a7 volatility
þ a8 volatility-squared þ a9 leverage
þ a10 tangibility þ a11 refinancing þ a12 runup
þ a13 6-month leading indicator growth
þ a14 relative size
þ k0  vector of year and industry fixed effects þ eÞ;
ð1Þ
13
Our results are not sensitive to excluding relative issue size as a regressor.
14
For example, managers can time debt issues to changing interest rates (Baker
et al., 2003; Barry et al., 2009).
15
CEO delta is also significantly different between bond issuers and equity issuers,
but as we show later, the difference disappears in the multivariate regressions.
2522 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529

Table 2
Summary statistics.

Variable All issues Equity issues Debt issues Equity – Debt

Mean Median Mean Median Mean Median t-stat z-stat
CEO vega ($ thou) 345 125 71 28 423 181 23.63 27.97
CEO delta ($ thou) 1951 555 1046 246 2208 639 6.54 16.39
Total assets ($ mil) 18,531 6866 2014 490 23,215 10,137 26.19 37.79
Tax status 0.032 0.030 0.025 0.019 0.034 0.032 8.29 12.07
Tobin’s Q 2.153 1.685 2.815 1.897 1.965 1.644 9.35 8.29
ROA 0.150 0.153 0.103 0.123 0.163 0.159 10.88 12.22
Volatility 0.347 0.301 0.547 0.504 0.291 0.275 29.34 34.54
Leverage 0.186 0.164 0.157 0.120 0.194 0.169 6.58 9.88
Tangibility 0.378 0.342 0.310 0.218 0.397 0.364 8.97 11.44
Refinancing 0.021 0.011 0.015 0.005 0.022 0.012 6.30 9.88
Runup 0.352 0.169 1.087 0.628 0.144 0.114 16.29 26.19
Leading indicator 0.010 0.009 0.013 0.011 0.009 0.007 3.19 5.34
Proceeds ($ thou) 641 207 195 105 767 253 12.67 14.86
Relative size 0.138 0.042 0.370 0.210 0.072 0.027 18.07 32.05

The sample consists of 825 seasoned common equity offerings and 2909 straight debt offerings during the period 1993–2007. All variables are as defined in Appendix B. All
dollar figures are expressed in December 2007 values.

Table 3
Correlation matrix.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)
(1) Log(1 + vega) 1
(2) Log(1 + delta) 0.453 1
(0.000)
(3) Log(assets) 0.626 0.432 1
(0.000) (0.000)
(4) Tax status 0.031 0.227 0.030 1
(0.060) (0.000) (0.067)
(5) Tobin’s Q 0.016 0.224 0.239 0.337 1
(0.321) (0.000) (0.000) (0.000)
(6) ROA 0.123 0.233 0.190 0.645 0.121 1
(0.000) (0.000) (0.000) (0.000) (0.000)
(7) Volatility 0.330 0.197 0.510 0.194 0.212 0.339 1
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
(8) Leverage 0.015 0.196 0.164 0.441 0.527 0.209 0.029 1
(0.375) (0.000) (0.000) (0.000) (0.000) (0.000) (0.076)
(9) Tangibility 0.013 0.061 0.147 0.034 0.164 0.150 0.176 0.133 1
(0.426) (0.000) (0.000) (0.041) (0.000) (0.000) (0.000) (0.000)
(10) Refinancing 0.089 0.003 0.128 0.090 0.100 0.038 0.005 0.294 0.107 1
(0.000) (0.860) (0.000) (0.000) (0.000) (0.021) (0.758) (0.000) (0.000)
(11) Runup 0.238 0.104 0.379 0.075 0.227 0.136 0.403 0.123 0.143 0.015 1
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.377)
(12) Leading indicator 0.024 0.026 0.027 0.024 0.003 0.025 0.040 0.002 0.035 0.016 0.025 1
(0.141) (0.116) (0.104) (0.141) (0.875) (0.131) (0.016) (0.899) (0.034) (0.319) (0.132)
(13) Relative size 0.296 0.144 0.549 0.020 0.401 0.192 0.393 0.243 0.168 0.081 0.501 0.019 1
(0.000) (0.000) (0.000) (0.218) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.255)

The table presents the correlation coefficients among explanatory variables in the probit model of firms’ security issue decisions (Eq. (1)). In parentheses are p-values
indicating whether the correlation coefficients are significantly different from zero. All variables are as defined in Appendix B.

where y is a binary variable that takes on a value of zero for debt
offerings and one for equity offerings, and U is the cumulative stan-
dard normal distribution function. We use logarithmic transforma-
tions of total assets, delta and vega to remove skewness in the
original data. Volatility squared is included to capture any non-lin-
ear effect.16
Table 3 presents the correlation coefficients among the explan-
atory variables. CEO vega and delta are highly correlated between
16
In addition to being a proxy for firm risk, stock return volatility is also a measure
of information asymmetry surrounding a firm. When the stock return volatility is very
high, managers may find it too expensive to issue equity because of the information
asymmetry even though equity financing is desirable from the standpoint of reducing
the probability of financial distress. Another possibility is that CEOs at firms with very
high risk may prefer debt to equity in order to exploit creditors through asset
substitution.
themselves and with firm size. Although this is not surprising in
that both equity incentive measures come from a CEO’s stock
and option portfolio and CEOs of larger firms tend to hold more
shares of stock and stock options, the high correlation does raise
concerns about potential multicollinearity when these variables
are simultaneously included in the regression model. To ensure
that our finding on the effect of CEO vega is not driven by any mul-
ticollinearity problems, we first estimate Eq. (1) with CEO vega as
the only explanatory variable and report the coefficient estimates
in column (1) of Table 4. In parentheses are p-values based on ro-
bust standard errors adjusted for heteroskedasticity and issuer
clustering. We find that CEO vega has a significantly negative coef-
ficient, which is consistent with our conjecture that CEOs with a
higher vega tend to avoid equity in favor of debt as a financing
vehicle. In column (2), we include all other explanatory variables
 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529 2523

Table 4 the imaginary firm is 5.8%. A one standard deviation increase in the
Probit analysis of security issue decisions. value of log(1 + vega) will decrease the probability by 2.6%, repre-
Independent variable Coefficient estimates (p-values) senting a 45% (2.6/5.8) drop.
(1) (2) (3) (4) With respect to our control variables, our findings are largely
consistent with those of earlier studies such as Jung et al.
Log (1 + vega) 0.495 0.123 0.131
(0.000) (0.000) (0.000)
(1996) and with the results of our univariate analysis. Specifically,
Log (1 + delta) 0.061 0.038 firms with a higher Tobin’s Q and recent stock price runup are
(0.145) (0.381) more likely to choose equity financing, while firms that are larger
Log (total assets) 0.819 0.841 0.902 and more profitable, pay more tax, and have greater refinancing
(0.000) (0.000) (0.000)
needs are more likely to resort to debt financing. It appears that
Tax status 6.063 6.253 4.668
(0.064) (0.053) (0.159) debt is the preferred choice for raising larger amounts of capital.
Tobin’s Q 0.255 0.231 0.223 We also find that stock offerings are more likely to occur during
(0.000) (0.001) (0.001) economic booms and that firms with lower leverage and more
ROA 3.770 3.778 4.098
tangible assets are more likely to issue debt, though these rela-
(0.006) (0.005) (0.003)
Volatility 2.923 2.821 2.834
tions are not statistically significant. The evidence on the effect
(0.000) (0.000) (0.000) of stock return volatility is fairly interesting. It appears that the
Volatility-squared 0.735 0.706 0.677 probability of equity offering increases with stock return volatility
(0.000) (0.000) (0.000) at a decreasing rate. The concave relation is consistent with vol-
Leverage 0.628 0.719 0.763
atility measuring both information asymmetry and the probabil-
(0.227) (0.165) (0.140)
Tangibility 0.426 0.433 0.317 ity of financial distress, which have opposite effects on the
(0.257) (0.245) (0.386) probability of equity offering. A higher stock return volatility
Refinancing 4.334 4.255 4.096 makes equity financing more attractive from the standpoint of
(0.008) (0.010) (0.016) reducing the probability of financial distress, but as the stock re-
Runup 0.958 0.952 0.958
(0.000) (0.000) (0.000)
turn volatility continues to rise, managers may become concerned
Leading indicator 1.807 1.783 2.153 that it is too expensive to issue equity in face of severe informa-
(0.297) (0.300) (0.201) tion asymmetry.
Relative size 1.672 1.687 1.582 Our model exhibits significant explanatory power; the specifi-
(0.000) (0.000) (0.000)
cations in columns (2) and (3) both have a pseudo-R2 over 70%,
Intercept 0.016 3.077 2.942 3.117
(0.985) (0.000) (0.000) (0.000) and are able to correctly classify about 95% of firms’ security issue
Industry fixed effects Included Included Included Included decisions, a number that compares favorably to those in other
Year fixed effects Included Included Included Included studies. For example, Marsh (1982) reports a 75% correct classifica-
Pseudo-R2 40.94% 70.90% 70.97% 70.57% tion rate, and the regressions in Jung et al. (1996) correctly classify
Observations 3734 3734 3734 3734
between 74% and 81% of the decisions.
The sample consists of 825 equity issues and 2909 debt issues from 1993 to 2007.
We perform a probit regression in which the dependent variable takes on a value of 3.3. Subsample analysis: Underlevered vs. overlevered
one for equity issues and zero for debt issues. All explanatory variables are as
defined in Appendix B. Two-sided p-values adjusted for heteroscedasticity and
firm-level clustering are reported in the parentheses below coefficient estimates. So far we have established that CEOs with a higher vega tend to
The coefficient estimates for industry and year fixed effects are suppressed. favor debt over equity as a financing vehicle. However, this evi-
dence is consistent with two explanations. The first explanation
is similar to the hypothesis in Berger et al. (1997) that, left to their
own device, managers will choose a leverage lower than optimal
except CEO delta, and find that the coefficient estimate of CEO vega
because of their risk aversion and/or the disciplinary effect of debt,
continues to be negative and highly significant. The inclusion of
and that managers whose interests are better aligned with those of
these control variables also increases the explanatory power of
shareholders take on more debt. The second explanation is that the
the model; the pseudo-R2 of the regression rises from a little over
preference for debt is an act of excessive risk taking undertaken by
40–70%. In column (3), we add CEO delta to the explanatory vari-
managers to maximize the value of their option ownership, albeit
able list, and find that it does not have a significant coefficient.17
potentially at the expense of shareholders.
On the other hand, the coefficient on CEO vega becomes slightly
We differentiate between these two hypotheses by separating
larger and more significant than in column (2). Given that vega is
issuing firms into those that are overlevered relative to their opti-
derived from a CEO’s option holdings while delta is derived from
mal capital structure and those that are underlevered. If vega plays
both option and stock holdings, our findings suggest that it is the
an incentive-aligning role, we expect CEOs with a higher vega to
stock option ownership that determines a CEO’s preference be-
make financing decisions that move their firms toward the optimal
tween debt and equity.
capture structure. Specifically, we expect this vega effect to be con-
We also find that the negative effect of CEO vega on the proba-
centrated in firms that are underlevered. On the other hand, if vega
bility of equity offering is significant in economic terms. Specifi-
induces excessive risk taking, we expect CEOs with a higher vega to
cally, we follow the commonly used approach in the literature
prefer debt to equity even when their firms are overlevered.
and focus on an imaginary firm for which all the independent vari-
The model we use to estimate a firm’s optimal leverage ratio is
ables are set equal to their respective sample means. We compute
built on previous studies such as Rajan and Zingales (1995), Berger
the marginal effects based on the coefficient estimates in column
et al. (1997), and Hovakimian et al. (2001), and it is specified as
(3) of Table 4.18 The predicted probability of issuing equity for
follows:

17 0
CEO delta does not enter significantly even in the absence of CEO vega (see Leverage ¼ a0 þ a1 logðtotal assetsÞ þ a2 ROA þ a3 Tobin s Q
column (4) of Table 4).
18
The marginal effect per standard deviation of variable j that has a coefficient of aj þ a4 tangibility þ a5 R&D ratio þ a6 SGA ratio
is /(x0 a)aj rj, where /() is the standard normal density function, x is a vector of þ k0  vector of year and industry fixed effects þ e;
values of the independent variables, a is the vector of coefficient estimates, and rj is
the standard deviation of variable j. ð2Þ
2524 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529

Table 5 Table 6
Coefficient estimates from optimal-leverage estimations. Subsample probit analysis of security issue decisions.

Independent variables Coefficient estimates (p-values) Independent variable Coefficient estimates (p-values)
Tobit OLS Full sample Overlevered Underlevered
Log (total assets) 0.017 0.013 Log (1 + vega) 0.132 0.135 0.183
(0.000) (0.000) (0.000) (0.006) (0.001)
ROA 0.346 0.321 Log (1 + delta) 0.064 0.149 0.013
(0.000) (0.000) (0.129) (0.012) (0.816)
Tobin’s Q 0.033 0.026 Log (total assets) 0.831 0.855 0.894
(0.000) (0.000) (0.000) (0.000) (0.000)
Tangibility 0.127 0.111 Tax status 5.957 2.801 11.053
(0.000) (0.000) (0.065) (0.543) (0.017)
R&D ratio 0.108 0.104 Tobin’s Q 0.212 0.101 0.430
(0.000) (0.000) (0.001) (0.221) (0.000)
SGA ratio 0.099 0.085 ROA 4.041 4.957 3.181
(0.000) (0.000) (0.003) (0.010) (0.060)
Intercept 0.134 0.154 Volatility 2.796 1.730 4.683
(0.000) (0.000) (0.000) (0.017) (0.000)
Industry fixed effects Included Included Volatility-squared 0.702 0.454 1.731
Year fixed effects Included Included (0.000) (0.018) (0.000)
Adjusted-R2 29.6% Leverage deviation 1.070 1.894 1.068
Observations 26,570 26,570 (0.072) (0.142) (0.590)
Tangibility 0.340 0.354 0.733
The sample used for optimal-leverage estimations consists of 26,570 firm-year (0.358) (0.553) (0.176)
observations from 1992 to 2007. All firms in ExecuComp with valid COMPUSTAT Refinancing 4.377 4.854 3.451
data are included. The dependent variable is market leverage, calculated as the book (0.011) (0.031) (0.272)
value of total debt divided by the market value of total assets, where the market Runup 0.952 1.397 0.531
value of total assets is equal to the book value of total assets minus the book value (0.000) (0.000) (0.000)
of common equity plus the market value of common equity. All explanatory vari- Leading indicator 1.820 1.420 1.894
ables are as defined in Appendix B. Coefficient estimates from both a double-cen- (0.291) (0.526) (0.538)
sored Tobit regression and an OLS regression are presented. Two-sided p-values Relative size 1.691 1.779 1.889
adjusted for heteroscedasticity and firm-level clustering are reported in the (0.000) (0.000) (0.000)
parentheses below coefficient estimates. The coefficient estimates for industry and Intercept 3.018 0.995 3.311
year fixed effects are suppressed. (0.000) (0.298) (0.001)
Industry fixed effects Included Included Included
Year fixed effects Included Included Included
Pseudo-R2 71.01% 69.47% 75.84%
where the R&D ratio is equal to R&D expenses divided by net sales, Observations 3734 1534 2200
the SGA ratio is equal to selling, general, and administrative
The sample consists of 825 equity issues and 2909 bond issues from 1993 to 2007.
expenses divided by net sales, and all other variables are as defined We perform a probit regression in which the dependent variable takes on a value of
earlier. We estimate the optimal-leverage model using both an OLS one for equity issues and zero for debt issues. All explanatory variables are as
and a double-censored Tobit approach, since leverage is bound be- defined in Appendix B. The underlevered (overlevered) firm-year observations are
tween 0 and 1. those with market leverage below (above) their optimal level estimated based on
the estimates in Table 5. Two-sided p-values adjusted for heteroscedasticity and
We use all ExecuComp firms from 1992 to 2007 to estimate the firm-level clustering are reported in the parentheses below coefficient estimates.
optimal-leverage regressions, and report the coefficient estimates The coefficient estimates for year and industry fixed effects are suppressed.
in Table 5. Consistent with extant evidence, we find that leverage
is higher in firms that are larger and have more tangible assets,
while it is lower in more profitable firms, firms with more invest-
ment opportunities, and firms with higher product and technology (with a positive leverage deviation) are more likely to issue equity
uniqueness measured by their R&D ratio and SGA ratio. and underlevered firms (with a negative leverage deviation) are
Based on the OLS coefficient estimates in Table 5, we estimate more likely to issue debt.
the optimal leverage ratio for each firm-year observation in our More importantly, we find that CEO vega has significant and
security offering sample. Whether an issuing firm is underlevered negative coefficients in all three regressions, suggesting that CEOs
or overlevered is determined at the end of the fiscal year prior to with a higher vega avoid equity financing and prefer debt financing
a security offering, thus avoiding any reverse-causality concern. regardless of whether their firms are overlevered. The proclivity of
The subsample of underlevered (overlevered) firms consists of high-vega CEOs toward debt even in overlevered companies is
companies whose debt ratios at the end of a given year are below inconsistent with the incentive alignment-based hypothesis in Ber-
(above) the optimal level. We re-estimate the probit model of ger et al. (1997); instead it supports the hypothesis that option
debt-equity choice in the whole sample and in each of the two ownership induces managers to take excessive risk that is not in
subsamples, and present the results in Table 6.19 In these regres- the best interest of shareholders.
sions, we introduce a new explanatory variable, leverage deviation,
which represents a firm’s deviation from its optimal capital structure
and is equal to the firm’s actual leverage minus its estimated optimal
4. Auxiliary analysis
leverage. We find that this variable has a positive effect on the prob-
ability of equity offering in all three regressions and that the effect is
4.1. An alternative model of optimal leverage
significant for the whole sample. This is consistent with firms trying
to move toward their optimal capital structure; overlevered firms
Recent research by Lemmon et al. (2008) highlights the impor-
tance of an unidentified time-invariant factor as a determinant of a
19
Our results are not sensitive to the choice of leverage measure. To be consistent
firm’s long-run capital structure. To capture this effect, we aug-
with the estimation approach employed by Berger et al. (1997) and Hovakimian et al. ment our optimal-leverage model specified in Eq. (2) by including
(2001), we only report the results based on market leverage. firm fixed effects. Table 7, Panel A presents the OLS regression
 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529 2525

Table 7 the importance of the time-invariant effect. But time-varying firm

Optimal-leverage estimation with firm fixed effects and subsample probit analysis of characteristics continue to have significant effects on capital struc-
security issue decisions.
ture. Similar to what we find in Table 5, larger firms and firms with
Independent variables Coefficient estimates (p-values) more tangible assets tend to have higher leverage, while more
OLS profitable firms and firms with more growth opportunities and a
Panel A: Optimal-leverage regression with firm fixed effects
higher level of uniqueness in products or technology tend to have
Log (total assets) 0.016 lower leverage. Based on the coefficient estimates in Panel A, we
(0.000) reconstruct the leverage deviation measure and use it to separate
ROA 0.273 our security-issuing firms into overlevered and underlevered subs-
(0.000)
amples. We then repeat the subsample probit analysis of Table 6
Tobin’s Q 0.017
(0.000) and find that our results are robust to the alternative specification
Tangibility 0.119 of optimal leverage. Coefficient estimates presented in Table 7, Pa-
(0.000) nel B show that CEO vega has a significant and negative effect on
R&D ratio 0.071
the probability of equity offering in both the underlevered and
(0.000)
SGA ratio 0.038
overlevered subsample.
(0.001)
Intercept 0.091 4.2. Incorporating preferred equity offerings and convertible debt
(0.000) offerings
Firm fixed effects Included
Year fixed effects Included
Adjusted-R2 70.3% While our analysis so far focuses on straight debt and common
Observations 26,570 equity, it is important to recognize that other types of security
Independent variable Coefficient estimates (p-values) issuance may also impact firm leverage and risk. For example,
although preferred equity does not increase financial leverage, its
Full sample Overlevered Underlevered
presence in a firm’s capital structure makes common equity riskier
Panel B: Subsample probit analysis of security issue decisions
due to its higher priority in the payment of dividends and upon liq-
Log (1 + vega) 0.136 0.142 0.167
(0.000) (0.004) (0.002) uidation. Similar to straight debt, convertible debt increases firm
Log (1 + delta) 0.064 0.047 0.092 leverage and equity risk, but to a lesser extent because of its poten-
(0.126) (0.421) (0.109) tial to be converted into common equity. Therefore, it would be
Log (total assets) 0.845 0.844 0.918 interesting to expand the set of financing options available to com-
(0.000) (0.000) (0.000)
Tax status 6.158 2.677 9.454
panies and examine how CEO vega is related to firms’ choice
(0.054) (0.536) (0.047) among straight debt, convertible debt, preferred stock, and com-
Tobin’s Q 0.206 0.125 0.333 mon stock. Toward that end, we extract information on preferred
(0.002) (0.117) (0.001) equity issues and convertible debt issues by public companies dur-
ROA 3.900 2.990 4.548
ing the period of 1993–2007 from the SDC database, and merge
(0.003) (0.069) (0.016)
Volatility 2.899 2.189 5.544 these offerings with our sample of straight debt and equity issues.
(0.000) (0.006) (0.045) Similar to the sample construction criteria in Section 2.1, we ex-
Volatility-squared 0.743 0.548 3.290 clude offerings by issuers who (i) are in the utility (two-digit SIC
(0.000) (0.008) (0.225) code: 49), financial (one-digit SIC code: 6), and public administra-
Leverage deviation 2.019 3.405 1.869
tion (one-digit SIC code: 9) industries, (ii) do not have complete
(0.005) (0.011) (0.234)
Tangibility 0.384 0.146 0.715 financial and stock price data available from COMPUSTAT and
(0.300) (0.793) (0.168) CRSP, (iii) do not have executive compensation data available in
Refinancing 4.111 1.664 7.271 Standard & Poor’s ExecuComp database, or (iv) offered more than
(0.015) (0.372) (0.009)
one type of security during the same fiscal year. Our final sample
Runup 0.926 1.057 0.996
(0.000) (0.000) (0.000) consists of 3791 security issues, which include 782 common stock
Leading indicator 1.537 2.612 5.663 offerings, 63 preferred stock offerings, 113 convertible debt offer-
(0.367) (0.194) (0.030) ings, and 2833 straight debt offerings. We estimate a multinomial
Relative size 1.695 1.824 1.742 logit regression of the four choices with common stock as the base
(0.000) (0.000) (0.000)
case and the same explanatory variables as in Table 4. The results
Intercept 3.119 0.484 3.143
(0.000) (0.531) (0.010) presented in Table 8 indicate that in each pairwise comparison,
Industry fixed effects Included Included Included CEOs with a higher vega are more likely to shun common stock
Year fixed effects Included Included Included and choose the financing vehicle that increases equity risk more.
Pseudo-R2 71.14% 71.70% 74.01%
The statistical significance of the relation increases monotonically
Observations 3734 1687 2047
from preferred equity to straight debt, with the p-value of the coef-
The sample used for the optimal-leverage regression in Panel A consists of 26,570 ficient on CEO vega dropping from 0.259 to 0.005. Overall, the evi-
firm-year observations from 1992 to 2007. All firms in ExecuComp with valid
COMPUSTAT data are included. The dependent variable is market leverage. The
dence from the multinomial logit analysis is consistent with our
sample used for the probit analysis of security issue decisions in Panel B consists of earlier finding that the risk-taking incentives provided by stock op-
825 common equity issues and 2909 straight debt issues. The dependent variable is tions encourage CEOs to prefer debt or debt-like securities to com-
equal to one for equity issues and zero for debt issues. The explanatory variables in mon equity.
both Panels A and B are as defined in Appendix B. Two-sided p-values adjusted for
heteroscedasticity and firm-level clustering are reported in the parentheses below
coefficient estimates. The coefficient estimates for year and firm/industry fixed 4.3. The effect of CEO vega on leverage changes
effects are suppressed.
The various types of public security offerings examined in the
previous sections carry potentially significant capital structure
results. We find that controlling for firm fixed effects enhances the implications, but they are not the only corporate decisions that
explanatory power of the target leverage model, raising the ad- can affect leverage. Focusing on them alone may overlook other
justed-R2 from about 30% in Table 5 to about 70%. This confirms important leverage-altering activities such as borrowing from
2526 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529

Table 8 Table 9
OLS regressions of leverage changes. Multinomial logit regression of security issue decisions.

Independent variable Coefficient estimates (p-values) Independent Coefficient estimates (p-values)

variables
Full sample Overlevered Underlevered 0: common 0: common 0: common
stock; stock; stock;
Log (1 + vega) 0.002 0.002 0.001
1: preferred 1: convertible 1: straight debt
(0.000) (0.001) (0.005)
stock debt
Log (total assets) 0.001 0.000 0.002
(0.009) (0.864) (0.002) Log (1 + vega) 0.251 0.140 0.188
Tax status 0.082 0.122 0.056 (0.259) (0.112) (0.005)
(0.000) (0.000) (0.017) Log (1 + delta) 0.006 0.119 0.129
ROA 0.000 0.000 0.000 (0.977) (0.252) (0.134)
(0.952) (0.012) (0.001) Log (total assets) 0.944 0.926 1.735
Tobin’s Q 0.002 0.001 0.001 (0.000) (0.000) (0.000)
(0.000) (0.000) (0.035) Tax status 0.212 9.793 5.219
Volatility 0.015 0.016 0.018 (0.979) (0.018) (0.308)
(0.008) (0.090) (0.004) Tobin’s Q 0.144 0.080 0.346
Volatility-squared 0.004 0.005 0.004 (0.695) (0.495) (0.007)
(0.127) (0.242) (0.052) ROA 2.534 0.579 8.553
Leverage deviation 0.155 0.194 0.134 (0.192) (0.623) (0.000)
(0.000) (0.000) (0.000) Volatility 2.599 0.273 0.080
R&D ratio 0.000 0.001 0.000 (0.045) (0.757) (0.905)
(0.078) (0.060) (0.398) Volatility-squared 2.635 2.869 1.785
Intercept 0.024 0.034 0.014 (0.112) (0.012) (0.062)
(0.048) (0.032) (0.304) Leverage 2.709 3.843 5.415
Industry fixed effects Included Included Included (0.162) (0.162) (0.000)
Year fixed effects Included Included Included Tangibility 0.760 1.803 1.364
Adjusted-R2 9.04% 9.33% 4.30% (0.159) (0.394) (0.000)
Observations 19,557 7903 11,654 Refinancing 4.671 3.554 9.226
(0.555) (0.558) (0.005)
The full sample consists of 19,557 firm-year observations from 1993 to 2007 Runup 2.225 0.445 1.863
obtained by merging the ExecuComp database with COMPUSTAT. The underlevered (0.001) (0.022) (0.000)
(overlevered) firm-year observations are those with market leverage below (above) Leading indicator 2.557 0.472 5.011
their optimal level based on the estimates in Table 4. The dependent variable is the (0.641) (0.937) (0.184)
change in a firm’s market leverage between two consecutive years. All explanatory Relative size 0.153 0.846 2.842
variables are as defined in Appendix B. Two-sided p-values adjusted for hetero- (0.923) (0.022) (0.000)
scedasticity and firm-level clustering are reported in the parentheses below coef- Intercept 30.432 31.869 5.486
ficient estimates. The coefficient estimates for year and industry fixed effects are (0.000) (0.000) (0.000)
suppressed. Industry fixed effects Included
Year fixed effects Included
Pseudo-R2 60.58%
Observations 3791

banks or other private lenders, private placement of equities, stock

The sample consists of 782 common stock offerings, 63 preferred stock offerings,
repurchase and debt retirement. In this section, we take a more
113 convertible debt offerings, and 2833 straight debt offerings during the period
aggregate view and examine overall changes in leverage in relation 1993–2007. Common stock offerings are the comparison category in the multi-
to CEO vega.20 For this analysis, we construct a sample of 19,577 nomial logit regression. All explanatory variables are as defined in Appendix B.
firm-year observations from 1993 to 2007 by merging COMPUSTAT Two-sided p-values adjusted for heteroscedasticity and firm-level clustering are
with the ExecuComp database. The dependent variable is the change reported in the parentheses below coefficient estimates. The coefficient estimates
for year and industry fixed effects are suppressed.
in a firm’s leverage between two consecutive years, i.e., levera-
get+1  leveraget, and CEO vega remains the key explanatory variable
in the year prior to the security offering; (ii) replace the ratio of tax
with leverage deviation, firm size, tax status, ROA, Tobin’s Q, volatil-
payment to total assets with the presence of net operating loss car-
ity (linear and quadratic forms) and the R&D expense to sales ratio as
ryforward (NOLC) as a proxy for a firm’s tax status; (iii) re-estimate
control variables. We estimate the leverage change model in an OLS
the leverage deviation measure by following Korajczyk and Levy
framework for the full sample as well as the overlevered and under-
(2003) to augment the optimal-leverage model with two macro-
levered subsamples. The coefficient estimates presented in Table 9
economic variables: the CRSP value-weighted return over the past
show that leverage changes are significantly and positively related
two years and the growth rate of the leading indicator over the
to CEO vega in all three regressions, suggesting that CEOs with a
past year; (iv) replace the monthly stock return volatility over
higher vega are more aggressive in levering up their firms, even
the past five years with the daily stock return volatility over the
when their firms are already over the optimal leverage ratio. This
past year prior to the issue; (v) add Altman’s Z-score as another
is consistent with the evidence from the probit analysis of firm secu-
control variable to capture a firm’s default risk; (vi) replace the re-
rity issue decisions in Table 6.
turn on assets (EBITDA/Total assets) with the ratio of operating
cash flow to total assets; (vii) adjust all explanatory variables for
4.4. Robustness analysis
their respective industry medians (based on two-digit SIC codes);
(viii) winsorize all explanatory variables at their respective 1st
Our findings are robust to various empirical specifications of the
and 99th percentiles; and (ix) eliminate different-type offerings
probit model of debt-equity choice in Table 6. Specifically, we (i)
by the same issuer within one year of each other. Table 10 presents
include as additional explanatory variables CEO tenure, CEO foun-
a summary of the results from these sensitivity analyses. For brev-
der status, CEO total cash compensation, and firm leverage change
ity, we only report the coefficient estimates of CEO vega for the full
20
sample and the overlevered and underlevered subsamples.
An obvious drawback for this approach is that some leverage changes may not be
direct reflections of corporate debt policies. For example, firms usually take on the
Throughout all these model and sample variations, the coefficient
debt of target companies in acquisitions. Significant changes in assets due to either of CEO vega remains significant and negative, attesting to the
divestitures or mergers and acquisitions can impact leverage as well. robustness of our results.
 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529 2527

Table 10 more sensitive to stock return volatility, i.e., those with a higher
Sensitivity analysis of the probit model of security issue decisions. vega derived from their stock option holdings, tend to favor debt
Independent variable Coefficient estimates (p-values) over equity as a capital-raising vehicle. This relation is consistent
Full sample Overlevered Underlevered with two alternative hypotheses. The first hypothesis argues that
the debt preference of high-vega CEOs represents an attempt of
Panel A: Controlling for CEO tenure, whether CEO is founder, and CEO cash
compensation
better-aligned managers to move firms’ capital structure toward
Log (1 + vega) 0.152 0.168 0.182 optimum, while the second hypothesis contends that the debt
(0.000) (0.003) (0.017) preference reflects excessive risk taking by managers in order to
Observations 3459 1375 2084 maximize the value of their option holdings. To differentiate be-
Panel B: Controlling for the presence of net operating loss carryforward (NOLC) tween these two explanations, we classify security-issuing firms
Log (1 + vega) 0.122 0.134 0.163 into overlevered and underlevered subsamples depending on
(0.000) (0.006) (0.003)
whether their leverage is above or below the optimal level. We find
Observations 3734 1534 2200
that the probability of debt offering increases with CEO vega in
Panel C: Leverage deviation estimated with two macro variables included as
both subsamples. While the effect of vega in the underlevered sub-
additional determinants of optimal leverage
Log (1 + vega) 0.132 0.133 0.168 sample is consistent with the incentive alignment hypothesis, the
(0.000) (0.006) (0.003) evidence from the overlevered subsample suggests that managers
Observations 3734 1527 2207 indeed take on too much risk in response to the convex payoff
Panel D: Controlling for daily stock return volatility structure of stock options. Our results highlight an unintended
Log (1 + vega) 0.130 0.136 0.189 consequence of executive stock options and suggest that firms
(0.000) (0.007) (0.001)
should exercise some restraint in compensating and incentivizing
Observations 3689 1506 2183
their executives with options. A careful evaluation of the benefits
Panel E: Controlling for Z-score
and costs of stock options is warranted in determining the use of
Log (1 + vega) 0.143 0.143 0.194
(0.000) (0.010) (0.001)
options in executive pay packages.
Observations 3476 1405 2071
Panel F: Controlling for operating cash flows Appendix A. Estimating the delta and vega of an executive’s
Log (1 + vega) 0.127 0.126 0.181 stock and option portfolio
(0.001) (0.012) (0.002)
Observations 3733 1534 2199
A.1. Delta and vega of a portfolio of stock options
Panel G: Using explanatory variables adjusted for industry means
Log (1 + vega) 0.132 0.138 0.184
(0.000) (0.005) (0.001) We calculate the value of a call option, c, and the sensitivities of
Observations 3734 1534 2200 a call option’s value to the underlying stock price and stock return
Panel H: Using explanatory variables winsorized at the 1st and 99th percentiles volatility, @c/@S and @c/@ r, respectively, using the Black–Scholes
Log (1 + vega) 0.129 0.136 0.173 formula (Black and Scholes, 1973) for valuing European call op-
(0.000) (0.006) (0.002) tions, as modified by Merton (1973) to account for dividend
Observations 3734 1534 2200 payouts.
Panel I: Eliminating different-type security offerings by the same issuer within a
one-year period
Log (1 + vega) 0.135 0.147 0.203 c ¼ SedT NðZÞ  XerT NðZ  rT 1=2 Þ
(0.000) (0.002) (0.001) @c=@S ¼ edT NðZÞ
Observations 3694 1514 2180
@c=@ r ¼ SedT nðZÞT 1=2
The table summarizes the regression results of variations of the probit model of
security issue decisions estimated in Table 6. For brevity, only the coefficient esti-
mates of CEO vega for the full sample and the overlevered and underlevered
where Z = (ln(S/X) + T(r  d + r2/2))/(rT1/2), S is the price of the
subsamples are reported. The number of observations varies depending on data
availability and sample restrictions. Specifically, we (a) include as additional underlying stock, X is the exercise price of the option, T is the time
explanatory variables CEO tenure, CEO founder status, CEO total cash compensa- to maturity of the option in years, r is the natural logarithm of the
tion, and firm leverage change in the year prior to the security offering; (b) replace risk-free interest rate, d is the natural logarithm of the expected div-
the ratio of tax payment to total assets with the presence of net operating loss idend yield on the underlying stock over the life of the option, r is
carryforward (NOLC) as a proxy for a firm’s tax status; (c) re-estimate the leverage
the expected annualized stock-return volatility over the life of the
deviation measure by following Korajczyk and Levy (2003) to augment the optimal-
leverage model with two macroeconomic variables: the CRSP value-weighted option, N() is the c.d.f. of the standard normal distribution, and
return over the past two years and the growth rate of the leading indicator over the n() is the p.d.f. of the standard normal distribution.
past year; (d) replace the monthly stock return volatility over the past five years Following the definitions in Core and Guay (2002), for a single
with the daily stock return volatility over the past year prior to the issue; (e) add
call option, delta is the change in the option’s value per 1% increase
Altman’s Z-score as another control variable to capture a firm’s default risk; (f)
replace the return on assets (EBITDA/total assets) with the ratio of operating cash
in the firm’s stock price = oc/oS  (1%  S) and vega is the change in
flow to total assets; (g) adjust all explanatory variables for their respective industry the option’s value per 1% increase in the firm’s annualized stock re-
medians (based on 2-digit SIC codes); (h) winsorize all explanatory variables at turn volatility = oc/or  1%.
their respective 1st and 99th percentiles; and (i) eliminate different-type offerings For a portfolio of N stock options, delta is the change in the
by the same issuer within one year of each other.
value of the option portfolio per 1% increase in stock
price = oc/oS  1%  S  N, vega is the change in the value of the
5. Conclusion option portfolio per 1% increase in stock return volatility = oc/
or  1%  N.
As conventional wisdom goes, managerial equity incentives
help alleviate the manager–shareholder agency problems inherent A.2. Delta and vega of an executive’s fiscal-year-end option portfolio
to large public corporations. However, our study shows that in the
context of firms’ security issue decisions, executive stock options We compute the delta and vega of each executive’s fiscal-year-
can lead to actions that do not appear to be in the best interest end option portfolio using the approximation method proposed by
of shareholders. Specifically, we find that CEOs whose wealth is Core and Guay (2002). ExecuComp provides such details as size,
2528 Z. Dong et al. / Journal of Banking & Finance 34 (2010) 2518–2529

exercise price, and time to maturity for each of the current year’s Appendix B (continued)
option grants, but for previously granted options (exercisable or
unexercisable), it merely gives aggregate size and realizable value Variables Definitions
(the potential gains from exercising all options at the fiscal-year- 60 + item 25  item 199) divided by the
end price). Core and Guay’s method is used to estimate the exercise book value of assets
price and time to maturity for these options so that the formulae in ROA Earnings before interest, tax, depreciation
Section A.1 can be applied. and amortization (EBITDA, item 13)
divided by the book value of total assets
1. We directly apply the above formula to calculate the delta and Tangibility Net book value of plant, property, and
vega of each current-year option grant. The delta and vega of equipment (item 8) divided by the book
the portfolio of newly granted options are the sum of the delta value of total assets
and vega of each new grant. Refinancing Long-term debt due in one year (item 44)
2. After removing newly granted options, if any, from the fiscal- divided by the book value of total assets
year-end option portfolio, we obtain a portfolio of previously (item 6)
granted options only. Some of these options are exercisable Leverage Book value of long-term and short-term
(vested) and others are unexercisable (unvested). We compute debt (item 9 + item 34) divided by the
the delta and vega separately for the portfolio of exercisable market value of assets, which is equal to
options and the portfolio of unexercisable options. the book value of assets minus the book
Exercise price: For each portfolio, we first divide the aggregate value of common equity plus the market
realizable value by the number of options in the portfolio, value of common equity (item 6  item
which gives the average of (stock price – exercise price). We 60 + item 25  item 199)
then subtract this number from the stock price to arrive at Proceeds Amount of capital raised from an offering
the average exercise price. (Data source: SDC)
Time to maturity: For unexercisable options, we set the average Relative size Proceeds from an offering divided by the
time to maturity equal to one year less than the time to matu- book value of assets
rity of the current year’s options grants, or equal to 9 years if no Runup Stock return in excess of the CRSP value-
grant was made in the current year; for exercisable options, we weighted return over the year prior to a
set the average time to maturity equal to 4 years less than the security offering
time to maturity of the current year’s options grants, or 6 years 6-month leading 6-month growth rate of the leading
if no grant was made in the current year. indicator indicator
Using the imputed average exercise price and average time to CEO delta Change in the value of a CEO’s stock and
maturity, we can apply the formulae in Appendix A to calculate option portfolio per 1% increase in stock
the delta and vega of the two portfolios of previously granted price
options. CEO vega Change in the value of a CEO’s stock and
3. The delta and vega of an executive’s entire option portfolio is option portfolio per 1% increase in the
the sum of the delta and vega of (i) the portfolio of newly annualized stock return volatility
granted options, (ii) the portfolio of previously granted, unexer- R&D ratio R&D expenses (item 46) divided by net
cisable options, and (iii) the portfolio of previously granted, sales
exercisable options. SGA ratio Selling, general, and administrative
expense (item 189) divided by net sales
A.3. Delta and vega of an executive’s fiscal-year-end stock and stock Leverage Actual leverage – estimated optimal
option portfolio deviation leverage

The delta of one share of stock (common or restricted) is equal

to 1%  S and the delta of a portfolio of N shares of stock is equal to
1%  S  N. Therefore, the delta of an executive’s stock and stock
option portfolio is equal to the sum of the delta of the stock port-
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