Debt, Performance-Based Incentives, and Firm Performance

Abstract

We identify conditions of prior performance and pay-performance sensitivity under which an increase in incentives is associated with improved performance. We find that increasing sensitivity increases risk-adjusted performance in firms with poor prior performance, but has little impact on high-performance firms. We also observe that firms choose higher pay-performance sensitivity when the probability of wealth transfers to bondholders is high(e.g., in low-growth, high-debt firms). Pay-performance sensitivity to stock prices is important. If carefully implemented under the appropriate conditions, it can provide effective incentives for improving firm performance.