Equity-based Compensation, Dynamic Investment and Capital Structure

We develop a continuous-time structural model to characterize the manager-shareholder conflict over the choice of dynamic investment when the manager is compensated with cash salary, stock and option. We then focus on investigating the dissimilar impact of stock and option compensations on the intertwined corporate investment dynamics and the capital structure decision. Our calibrated model predicts that granting managers more equity-based compensation, particular options, accelerates corporate investment. Increasing stock compensation monotonically incentivizes firms to use a higher leverage, whereas an increase in option compensation induces first a higher and then a lower incentive for debt issuance. We also highlight heterogeneous effects of stock and option compensations on firm value and agency costs of debt overhang across firms with different values of growth opportunities. Our model reconciles with the practically observed compensation structure shift that firms appear to use stock as opposed to cash salary to offset the reduction of option usage since the adoption of FAS 123R in 2005.