Managerial Equity Incentives and Convertible Debt Decisions: Economic Considerations Versus Financial Reporting Incentives

I examine the effect of equity incentives on firms' decisions to issue convertible debt and select convertible debt designs that dilute earnings per share (EPS). Agency studies predict that equity incentives provide management with risk-taking incentives and thus, motivate executives to issue convertible debt and select dilutive convertible debt designs. However, convertible debt financing imposes a reporting cost on the firm because accountants incorporate the dilutive impact of this security into EPS numbers. Since EPS numbers are linked with stock prices, I argue that equity incentives motivate managers to be sensitive to the financial reporting costs of convertible debt financing. Hence, equity incentives will influence managers to avoid issuing convertible debt and selecting convertible debt designs that dilute EPS. I test these competing hypotheses in two essays.

In the first essay, I find no significant effect of managerial ownership on the issuance decision. Further, I find no significant impact of CEO ownership on the design decision. However, I find that CFO ownership is associated with a lower likelihood of choosing dilutive convertible debt designs, but only when the firm stock price is more sensitive to EPS numbers. In the second essay, I find that the sensitivity of managerial options to the stock price (delta) and to the stock return volatility (vega) have no significant impact on the issuance decision. Further, CEO delta and CFO vega are associated with a higher likelihood of selecting dilutive convertible debt designs. However, CEO vega and CFO delta do not affect the design decision.