The Effect of CEO
Reputation on the Cost of
Debt
MSc in Business Administration - Organization and
Management Control
Master thesis
Student: Hannah Hazel Bruñola, S2311240 Thesis Supervisor: Dr. Y. Karaibrahimoglu
Co-assessor: Dr. D.B. Veltrop January 22, 2018 Word count: 12,011
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Abstract
Creditors are concerned in protecting their investments and set the price of debt to reflect the risks they bear in guaranteeing the debt contract’s validity. As CEO reputation serves as a signal for the stakeholders on the organization’s potential and performance, this study examines the impact of CEO reputation of the S&P 500 companies on the cost of debt. Using panel data from 1992-2014, the study provides evidence that CEO reputation, proxied as CEO press coverage divided by firm press coverage, decreases the cost of debt under the efficient contracting perspective. Furthermore, the findings show that CEO overconfidence strengthens the impact of CEO reputation on the cost of debt under the efficient contracting perspective. The study also provides evidence that board independence weakens the relation between CEO reputation and the cost of debt under the efficient contracting perspective. Finally, the findings suggest that CEO reputation lowers the cost of debt and this relation is moderated by CEO overconfidence and board independence.
Keywords: CEO reputation, Cost of debt, CEO overconfidence, Board independence
1. Introduction
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently. – Warren Buffett, CEO of Berkshire Hathaway.
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The agency theory explains that the goals or desires of the principal and agent may be in conflict and the verification of the agent’s real actions is hard. Another problem is the risk sharing, the principal and agent may both have different risk preferences (Eisenhardt, 1989). Managers have the incentives to seize wealth from debtholders to shareholders after a loan contract has been finalized (Jensen and Meckling, 1976), which is the agency cost of debt. This is usually characterized in terms of asset substitution or the problem of risk shifting (Francis et al., 2016). Naturally, creditors consider the risks involved in their lending decisions. According to the Upper Echelon theory (UET) managerial experiences, values and cognitive styles, like risks preferences, influence the choices of managers, and, therefore, corporate decisions (Hambrick and Mason, 1984). The theory affirms that managerial background characteristics, such as overconfidence level, estimate the outcomes, choices and performance levels of the organizations (Hambrick and Mason, 1984). Chief Executive Officer (CEO) reputation, as other apparent characteristics of executives, serves as a signal for the stakeholders on the organization’s potential (Certo, 2003), and signals the managerial quality (Milbourn, 2003). A person’s reputation and image can be the most valuable intangible asset, either as an actor or actress, a political candidate, or as a CEO representing an organization (Fetscherin, 2015). A CEO often receives intense public attention and may be seen by the public as the ‘human face’ of an organization (Fetscherin, 2015). Anything that CEO’s and other top executives say or do in public can impact their organization and vice versa. As they are often seen as the organization’s spokespeople and it is generally expected from them to reflect the views and vision of their organizations. The consequences of a CEO’s strategic choices are observable, making the success or failure of previous strategic choices major determinants of his or her reputation (Hayward and Hambrick, 1997; Hayward et al., 2004; Wiesenfeld et al., 2008).
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through a survey by Donelson et al. (2015) regarding financial statement quality and debt contracting, they find that the third most valuable factor that banks consider for lending decisions are “character, reputation and experience of management”.
Academics argue that the reputation of the CEO affects the performance and reputation of an
organization (Graffin et al., 2012).There are two contracting views; (i) efficient contracting versus
(ii) rent extraction. According to the efficient contracting perspective, well-regarded CEO’s are likely to avoid actions that involve opportunistic behavior (Fama, 1980). Jian and Lee (2011), and Koh (2011) argue that efficient contracting proposes a positive effect of CEO reputation on the organization’s performance. CEO’s use their abilities to improve or increase organizational performance to preserve and increase their reputation (Fama, 1980). CEO’s with a good reputation have more to lose, in terms of their own human capital, if they make strategic choices that result into poor discretionary quality (Francis et al., 2008). Therefore, CEO’s use their ability more for the best interest of his or her organization. CEO ability reduces earnings restatement and errors in the provisions of bad debt (Demerjian et al., 2012), and forecasts more accurate management earnings (Baik et al., 2011). The default risks and information risks are then reduced, which are primary factors that banks consider for lending decisions (Francis et al., 2016). Smith and Warner (1979) indicate that the price of the debt is set by creditors to reflect the difficulties in guaranteeing the validity of the debt contract. It is expected that reputed CEO’s will give more guarantees in a debt contract hence they avoid actions that can result into higher costs of capital or debt for their firms. Therefore, the efficient contracting hypothesis predicts that firms managed by reputed CEO’s have lower cost of debt.
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The UET indicates that managerial characteristics estimate organizational outcomes, choices and performances (Hambrick and Mason, 1984). The UET suggests that the more complex the decisions are to be made, the more important the characteristics of the decision-makers are. The theory also argues that because of bounded rationality, decision-makers will make decisions based on their cognitive, social and physiological characteristics. Previous literature proved that irrational behavior in management significantly impacts decisions in corporate financing. Furthermore, Abor (2007) argues that overly optimistic CEO’s show stronger relation between debt issue and financing deficit than non-optimistic CEO’s. Hayward and Hambrick (1997) also state that CEO overconfidence can negatively influence the future performance of an organization. Malmendier and Tate (2005) find supporting evidence that overconfident CEO’s engage in riskier
corporate decisions and overinvestment, which will affect CEO reputation.It is therefore expected
that managerial characteristics, more specifically CEO overconfidence, will moderate the relation between the CEO reputation and the cost of debt.
The agency theory explains that the goals of a principal and agent can be in conflict and it is
difficult to verify the agent’s real actions (Eisenhardt, 1989). In corporate governance, an
important mechanism to monitor the management is the board of directors (Fama and Jensen, 1983). Literature generally indicates that independent board of directors is the most effective in monitoring and controlling organizational activities. As mentioned before, banks are monitors themselves (Carletti, 2004). Independent board of directors can substitute a portion of the creditor’s monitoring activities, thereby decreasing the creditor’s costs. Furthermore, Anderson et al. (2004) find that boards dominated by independent directors have lower cost of debt financing. Since board independence lowers the cost of debt, it is expected that the board independence will moderate the relation between the CEO reputation and the cost of debt.
Using a sample of 396 CEO’s and 276 firms from the S&P 500 non-financial companies over the period of 1992-2014, the study finds evidence that CEO reputation lowers the cost of debt under the efficient contracting perspective. Furthermore, the findings show that CEO overconfidence and board independence strengthen the impact of CEO reputation on the cost of debt under the efficient contracting perspective. Suggesting that the moderating effect of CEO overconfidence and board independence further lowers the cost of debt.
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2. Literature review
2.1 Prior Research and hypotheses development
Traditional banking theory indicates that the probability of default is one of the most important determinants of the cost of debt. Many literatures show that the higher the default risk is of an organization, the higher the interest rates of debt are (e.g. Berger and Udell, 1990; Strahan, 1999). The default risk is affected by the agency risk and information risk between management and stakeholders (Bhojraj and Sengupta, 2003). Theoretical work further proposes that the costs and terms of debt are affected by asymmetric information and agency costs (e.g. Rajan and Winton, 1995). There is an emerging stream of literature examining the factors determining the terms of debt. For instance, Strahan (1999) finds that organizations who face more risks, such as highly leveraged organizations, pay higher interest rates on their debt. Datta et al. (1999) also find evidence that interest rates are lower when firm reputation is more developed which is consistent with the prediction of Diamond (1989). Anderson et al. (2004) find that the board of director’s independence and size are associated with a lower cost of debt financing, since the board of directors affect the credibility of disclosed information (Klein, 2002) and the agency costs (Richardson, 2006). Hasan, Park, and Wu (2012) find that when organizations have more predictable earnings, they can get more favorable debt terms.
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The reputation of a CEO, as other apparent characteristics of executives, indicates the managerial quality of an organization (Milbourn, 2003), and serves as a signal for the stakeholders on the organization’s potential and performance (Certo, 2003; Gaines-Ross, 2000). According to the
efficient contracting perspective, more reputed CEO’s are more likely to be associated with lower
cost of debt because they have more to lose if they systematically exploit reporting discretion to portray their organization in a better light than it really is. The hypothesis builds on the model of Fama (1980), where CEO’s are likely to avoid actions that involve opportunistic behavior because their history is used to infer personal traits, like his or her credibility. Being aware of this, the CEO has incentives to act in ways that may affect the market’s beliefs. Additionally, reputation is fragile because it takes a length of time to build the reputation and only a short time to destroy it (Hall, 1992). This fragility reinforces the efficient contracting perspective, once a CEO has established a good reputation, they have strong incentives to take competent strategic choices. To preserve or increase this reputation, they will likely make more use of their knowledge and abilities and take appropriate strategic choices to increase organizational performance (Fama, 1980). Even though CEO’s may not directly suffer gains or losses in their compensations from the current firm performance, the failure or success of the firm is a condition whether they will be kept in the future and their future compensations (e.g. Milbourn, 2003).
Studies find that managers with more knowledge and abilities are better in the selection and execution of projects (Chemmanur and Paeglis, 2005), and are more efficient in turning resources into revenues (Demerjian et al., 2012). Also, information opacity is reduced because the CEO’s ability lessens earnings restatement and errors in the provisions of bad debt (Demerjian et al., 2012); and more accurate management earnings are forecasted (Baik et al., 2011). Default risk and information risk are primary factors that banks consider for lending decisions (Francis et al., 2016), therefore organizations with lower default risk and information risk can borrow at more favorable terms (Berger and Udell, 1990). As observed by Smith and Warner (1979), creditor’s concerns primarily lie in protecting their investments, and further Smith and Warner (1979) also indicate that the price of the debt is set by creditors to reflect the difficulties and risks they bear in guaranteeing the validity of the debt contract. In a recent study of Francis et al. (2016), they argue that managers with better abilities can attain more favorable loan terms, as it signals firm future performance and reduces information opacity. According to the previous studies and the efficient contracting perspective more reputed CEO’s will make more use of their abilities to avoid reputation loss, hence reducing the risks for their creditors. Altogether, it is expected in this study that the creditors will offer a lower cost of debt to more reputed CEO’s.
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On the contrary, according to the rent extraction perspective, more reputed CEO’s are more likely to exploit reporting discretion to meet performance expectations. The rent extraction perspective argues that overemphasis on improving personal career will motivate the CEO’s more to meet the stakeholder’s performance expectations (Francis et al., 2008). Malmendier and Tate (2009) show evidence that agency problems can exacerbate when the CEO’s power increases, e.g. award-winning CEO’s can make use of their reputation to extract rents; and the perks of their success can distract them to run their organization’s effectively, which results to not meeting or not exceeding performance expectations. Stakeholders will keep raising their expectations on future performance, but when this is not met the stakeholder’s attitude towards the organization may change (Fombrun, 1996). The increase of expectations resulting from CEO reputation can become a “burden of celebrities” (Fombrun, 1996), because it is more difficult for the CEO’s to please their stakeholders. CEO’s might be forced to protect their reputation (Fombrun, 1996), possibly taking riskier strategies and investments (Graffin et al., 2012), or even manipulating earnings to manage market perceptions (Francis et al., 2008), resulting into value destruction for the organization’s claimholders and eroding performance. Financial theory explains that managers work primarily for their shareholders and engage in policies that are in the interest of their shareholders. Previous literature indicated that managers have incentives to take wealth from the debtholders to their shareholders after a debt contract has been completed (e.g. Jensen & Meckling, 1976), this is the agency cost of debt, which is usually in the form of asset substitution or risk shifting (Francis et al., 2016). As mentioned before, creditor’s concerns primarily lie in protecting their investments (Smith and Warner, 1979). Because of the agency problem, banks are monitors themselves (Carletti, 2004). Monitoring helps them detect their borrower’s opportunistic behavior
and to penalize them either by liquidation or renegotiation1. The price of debt is set by the creditors
to reflect the difficulties in guaranteeing the validity of the debt contract (Smith and Warner, 1979). The high interest rate increases the creditors bargaining power in renegotiations after the debt contract has been completed (Gorton and Kahn, 2000), and additionally requires organizations to make fees higher in servicing the debt, accordingly reducing the borrower’s ability to engage in alternative investments that are disadvantageous to the debtholder’s value. Taken altogether, it is expected under the rent extraction perspective that the creditors will demand higher interest rates to compensate them from bearing the risks when lending to highly reputed CEO’s.
Hypothesis 1b: Under the rent extraction hypothesis, CEO reputation increases the cost of debt.
According to the UET, managerial characteristics affect the organizational outcomes (Hambrick and Mason, 1984). A study shows that characteristics of individual managers can affect a firm’s
1 According to the relationship banking theory, the close relationship between the lender and
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financial leverage (Oliver, 2005). Abor (2007) further demonstrates that overly optimistic CEO’s show stronger relation between debt issue and financing deficit than non-optimistic CEO’s. It was also found that overconfidence of management, and the illusion of control and sensation seeking cause higher corporate debts (Ben-David et al., 2007). Hayward and Hambrick (1997) state that CEO overconfidence can negatively influence the future performance of an organization. Supporting evidence was found by Malmendier and Tate (2005) that overconfident CEO’s engage in riskier corporate decisions and overinvestment. When CEO’s become overly confident, projects are overvalued, and they invest in negative net present value’s (NPV) investments (Heaton, 2002). Overconfidence is the tendency of individuals to think that they are better than they really are. They think they have better abilities, judgment, and/or prospects for successful life outcomes. Individuals who are overconfident tend to overestimate the returns they generate from uncertain projects, either because of their tendency to expect good outcomes, or because of overestimation of their own efficacy to bring success (Griffin and Tversky, 1992). Literature proves that irrational behavior in management significantly impacts decisions in corporate financing. A recent study provides evidence of other important effects of managerial overconfidence, such as overconfidence is associated with a larger probability of financial fraud and earnings management (Schrand and Zechman, 2012). Hribar and Yang (2011) also find that overconfidence can more likely lead to optimistically announce biased forecasts. Creditors are concerned with protecting their investments and the price of debt is set to reflect the risks they bear in guaranteeing the debt contract’s validity (Smith and Warner, 1979). Taken altogether, it is more likely that CEO overconfidence will further increase the cost of debt. Under the efficient contracting perspective, it is expected that reputed CEO’s are more likely to be associated with lower cost of debt. When a
CEO is overconfident the creditors bear greater risks, and will increase the cost of debtto reflect
the difficulties and risks they bear in guaranteeing the validity of the debt contract (Smith and
Warner, 1979), thereby weakening the relation between CEO reputation and the cost of debt under the efficient contracting perspective. Under the rent extraction perspective, it is expected that reputed CEO’s are more likely to be associated with higher cost of debt. When a CEO is overconfident the cost of debt will further increase, thereby strengthening the relation between
CEO reputation and the cost of debt under the rent extraction perspective2.
Hypothesis 2: CEO overconfidence strengthens (weakens) the relation between the CEO reputation and the cost of debt under the rent extraction hypothesis (the efficient contracting).
The agency theory suggests that goals or desires of a principal and an agent are or can be in conflict and that the agent’s real actions are hard to verify. Another problem of the agency theory is the risk sharing, because the principal and agent can, or may both have different risk preferences (Eisenhardt, 1989). Jensen and Meckling (1976) provide evidence that managers have the incentives to seize wealth from debtholders to shareholders after a loan contract has been finalized,
2 CEO overconfidence might also be the reason of having a higher CEO reputation. This relation
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which is the agency cost of debt. This is usually characterized in terms of asset substitution or the problem of risk shifting (Francis et al., 2016). Naturally, lenders consider and monitor the risks
involved in their lending decisions. In corporate governance literature, one of the most important
mechanisms to monitor the management is the board of directors (Fama and Jensen, 1983). Studies show that the board of directors influences the availability and credibility of information disclosed by the organizations (e.g. Klein, 2002), and exercises great influence in the agency costs (e.g. Richardson, 2006). It was also found that the board can influence an organization’s likelihood of bankruptcy and financial distress (Daily and Dalton, 1994; Elloumi and Gueyie, 2001). Prior literature generally indicates that independent board of directors is the most effective in monitoring and controlling organizational activities. In a recent study, empirical evidence was found that board independence is associated with lower cost of debt (Anderson et al., 2004), since more independent directors reduce managerial entrenchment and expropriation of resources (Byrd and Hickman, 1992). In a previous study it was also found that board independence is negatively related to the likelihood of fraud (Dechow et al., 1996), and to abnormal accruals (Klein, 2002). As corporate board and creditors are corporate governance mechanisms, earlier studies found a substitution effect among these two (e.g. Agrawal and Knoeber, 1996). If the board of directors substitute a portion of the creditors monitoring activities, the creditor’s and the board’s monitoring activities can complement each other, by that the creditors can reduce their monitoring intensities and costs. Taken altogether, it is expected that board independence further lowers the cost of debt. Under the efficient contracting perspective, it is expected that reputed CEO’s are more likely to be associated with lower cost of debt. Therefore, board independence strengthens the relation between CEO reputation and cost of debt under the efficient contracting perspective. Under the rent extraction perspective, it is expected that reputed CEO’s are more likely to be associated with higher cost of debt. Therefore, board independence weakens the relation between CEO reputation and cost of debt under the rent extraction perspective.
Hypothesis 3: Board independence strengthens (weakens) the relation between the CEO reputation and the cost of debt under the efficient contracting hypothesis (the rent extraction). Figure 1 Conceptual Model
CEO
Reputation Cost of Debt
CEO Overconfidence
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3. Methods
3.1 Data and sample
The sample is composed of the top-ranking officers of all S&P 500 non-financial companies over the period of 1992-2014, as identified from the ExecuComp database. In the study, a default assumption is that the top-ranking officer is the position of the CEO. Accordingly, when a CEO is named, the positions of president, chief operating officer, and chair of the board are excluded unless the CEO holds one or more of these positions, then the named CEO is retained. Additionally, the CEO’s of subsidiaries and divisions are excluded.
The sample selection process starts by the selection of all CEO’s of S&P 500 companies available on the ExecuComp database. The initial sample consists of 9,666 CEO-years observations over the 1992-2014 periods. Around 1,679 CEO-years observations from financial firms (SIC 6000-6799) and 1,323 CEO-years observations are excluded because of the ambiguity of the CEO’s position. Financial data is obtained from CompuStat and Wharton research data services (WRDS). The data available on the CompuStat and WRDS databases are only from the years 1999 until recent. During the process, 4,461 observations with missing firm-specific variables are eliminated. The final sample consists of 2,203 firm-year observations from 396 CEO’s and 276 firms over the 1999-2014 period.
CEO reputation can be considered as the total lasting image that stakeholders perceived based on the performance, ability and the values of the CEO. However, the assessment of the CEO’s reputation is multidimensional and is typically difficult to quantify. Milbourn (2003) attempts to empirically proxy for CEO reputation, relying on the number of press articles citing the CEO. Since the data on media count proxies for CEO reputation is available for all organizations, press-coverage-based proxies are also used in this research paper. For each CEO and firm, the press coverage data are collected from LexisNexis. For the dependent variable, the cost of debt, data is collected from the WRDS. The data for the moderator variables, CEO overconfidence and board independence, are collected from ExecuComp and BoardEx.
3.2 Model Specification
3.2.1 Model 1 specification. To test the impact of the CEO reputation on the cost of debt, the
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estimate, suggesting that CEO reputation is more likely to be associated with higher cost of debt. As reputed CEO’s are more likely to exploit reporting discretion to meet performance expectations, creating more risks for creditors and therefore a demand for higher compensation of bearing these risks. The following equation is Model 1:
(1) Cost of Debt = α + β1 CEO Reputation + β2 Size + β3 ROA + β4 PPE + β5 CR + β6 LEV + β7 MB + β8 NegE + Industry and Year dummies + ε
Where the dependent variable, cost of debt, is measured as the firm’s average interest rate on debt. The reported interest expense is divided by the average of the beginning and ending debt levels. Previous studies also used this approach to calculate interest rates (e.g. Francis et al., 2005; Minnis, 2011).
Cost of debt = Reported interest expense / Average Debt
The independent variable, CEO reputation, shows how parties external to the firm view the CEO, which is reflected in the number of articles that contains the CEO’s name and the company that appears in the Major World Publications in calendar year t (from the first year the CEO is appointed in the company). The concept is that when a CEO appears in major world publications more often than other CEO’s, he or she has a higher reputation (Milbourn, 2003). E.g. an executive recognized as an industry expert will be more often cited and interviewed by the media. An executive’s eminence in the press is observable by the market and is a potential trustworthy guide to the assessment of his or her ability. CEO reputation can represent as much as 50 percent of the firm’s reputation, making it an important antecedent of firm reputation (Gaines-Ross, 2000). The concept of firm reputation is the same as the CEO reputation, when a firm appears in major world publications more often than the others, it has a higher reputation. Graffin et al. (2010) suggest that executive and firm level have a reciprocal relationship and this relationship was empirically proven by Safón et al. (2011). Their results confirm that there is reciprocal influence between CEO reputation and firm reputation. The measurement for CEO reputation will therefore also consider the media coverage of the firm. The article count for CEO is denoted as CEO press coverage and for the firm as firm press coverage- total. It should be noted that not all press is necessarily ‘‘good’’ press. However, as Milbourn (2003) suggests it seems reasonable that publicity and reputation are overall positively related.
CEO reputation = number of CEO press coverage / number of the firm press coverage
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of Petersen and Rajan (1994) and Blackwell et al. (1998) that loan spread is inversely related to firm size. Therefore, it is expected to be negatively related to the cost of debt. Firm size is the natural log of total assets (Minnis, 2011).
Firm size = Ln (Assets)
Profitability is also included as a control variable because lenders are likely to charge less interest rates for firms that are more profitable as such firms are more likely to be able to pay back the debt. When a borrower’s assets are very liquid, conflicts may arise between the borrower and the lender. Accordingly, it is expected to be negatively related to the cost of debt. Profitability is measured as the return on assets (ROA).
ROA = Net Income / Total Assets
Tangible assets, such as PPE, can reduce the inappropriate transfer of assets from the debt holders to the management as such are less liquid and more easily identified. As the loan pricing literature suggests tangible assets, such as PPE, are inversely related to credit risk and, thus, the interest rate charged by lenders (e.g. Bharath et al., 2008; Kim et al., 2011). Hence, it is expected to be negatively related to the cost of debt. PPE is measured as the natural log of the total property, plant and equipment.
PPE = Ln (PPE)
Current ratio represents whether the firm can meet its short-term obligations. A high current ratio indicates that a firm is more likely to pay the lender back and assures lenders that the high profit and liquidity levels are results of real firm performance and not reporting manipulation, and thus, lower interest charges. Therefore, it is expected to be negatively related to the cost of debt. Current ratio is measured as the current assets divided by the current liabilities.
CR = Current Assets / Current Liabilities
Leverage is used to proxy for the firm’s risk of bankruptcy. It is positively associated with debt-related agency conflicts, since owners have more incentives to commit asset substitution when they have little equity. High variances are identified and to a disadvantage of the lenders net present value of projects are negative (Jensen and Meckling, 1976). It is expected to be positively related to the cost of debt, as firms with high debt usage are associated with more bankruptcy costs, resulting to an increase in the required rate of return to the creditors. Leverage is measured as total liabilities divided by the total assets (e.g. Minnis, 2011; Kim et al., 2011).
Leverage = Total liabilities / Total assets
Market to book ratio signals whether an investor is paying too much for what would be left if the firm goes bankrupt immediately. Market to book ratio is measured as market capitalization divided by total book value of the firm.
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There are firms with negative equity positions, to allow these unique features, the indicator variable Negative Equity is also included in the model (Minnis, 2011; Kim et al., 2011). Hence, it is expected to be negatively related to the cost of debt. Negative equity equals one if the total liabilities exceed the total assets (e.g. Minnis, 2011; Kim et al., 2011).
NegE = 1 if TL > TA
3.2.2 Model 2 specification. To test hypothesis 2, CEO overconfidence is added to the model.
In Model (2), the main variable of interest is the interaction term CEO Reputation * CEO
Overconfidence. It is expected to have a positive and significant coefficient estimate, indicating
that the moderating effect of CEO overconfidence increases the cost of debt. As overconfident CEO’s engage in riskier corporate decisions and overinvestment (Malmendier and Tate, 2005) and are also associated with a larger probability of financial fraud and earnings management (Schrand and Zechman, 2012), creditors will demand higher compensation for bearing these risks. The following equation is Model 2:
(2) Cost of Debt = α + β1 CEO_Reputation + β2 CEO_Overconfidence
+ β3 CEO Reputation * CEO_Overconfidence + β3 ROA + β4 PPE + β5 CR + β6 LEV + β7 MB + β8 NegE + Industry and Year dummies + ε
Where the measurement of the moderator variable, CEO overconfidence, is the average moneyness of the CEO’s option portfolio for each year (Hribar and Yang, 2016). It labels managers as overconfident when they expose themselves too much to the peculiar risk of their firms. CEO’s are classified as overconfident if they hold options with average money of at least 67 percent more than once during the sample period. Average moneyness is calculated by the realizable value per option divided by the average exercise price. The realizable value per option is estimated by the total reliable value of options divided by the number of exercisable options. The average exercise price is the difference between the year-end stock price and the realizable value per option. The CEO overconfidence dummy variable is used in the analysis. This dummy variable equals 1 if the CEO has options more than 67 percent in the money at least two times during his or her tenure, 0 otherwise. Once a CEO is identified as overconfident using this measure, he or she remains so during the rest of the sample period.
Average moneyness = Realizable value per option / average exercise price where;
realizable value per option = total realizable value of options / n of exercisable options average exercise price = year-end stock price – realizable value per option
CEO overconfidence = 1 if CEO has options more than 67 percent in the money at least
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An important note is that CEO overconfidence might be the reason of having higher reputation as well. This is tested in the robustness checks.
3.2.3 Model 3 specification. To test hypothesis 3, board independence is added to the model.
In Model (3), the main variable of interest is the interaction term CEO Reputation * Board
Independence. It is expected to have a negative and significant coefficient estimate, indicating that
the moderating effect of board independence further decreases the cost of debt. As independent board members are the most effective in monitoring and controlling organizational activities, they
substitute a portion of the creditors monitoring activities, through that creditors will reduce their monitoring intensities and costs. The following equation is Model 3:
(3) Cost of Debt = α + β1 CEO_Reputation + β2 Board_Independence
+ β3 CEO Reputation * Board_Independence + β3 ROA + β4 PPE
+ β5 CR + β6 LEV + β7 MB + β8 NegE + Industry and Year dummies + ε
Where the moderator variable, board independence is the number of independent directors divided by board size (Andersson et al., 2004), which is the fraction of independent directors.
Board Independence = n of independent directors / board size
To test the models, ordinary least square (OLS) regression is conducted.
4. Results
4.1 Descriptive and Univariate Statistics
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mean of $1.4701, with a standard deviation of $0.1658, and a minimum and maximum of $1.0754 and $1.8290. Which indicates that the firms in the sample have a relatively low level of tangible assets, which is about 15.77 percent of the total assets. The average current ratio is 1.7312, suggesting that the average firm in the sample can pay off its obligations. The long-term debt, on average comprises 3.38 percent of the sample firms to total capital. The market to book average is 4.1409, which suggests that the average firm’s stocks are overvalued. Finally, on average, about 1.32 percent of the firms in the sample have negative equity during the sample period.
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Table 1
Sample description
Panel A: Descriptive Statistics for variable measures
The table provides summary statistics for the data employed in the analysis. The data set is comprised of 2,203 firm-year observations for the period 1999-2014. The Cost of Debt is the actual interest expense paid relative to the average of the short and long-term debt at the beginning and end of the fiscal year. CEO Reputation is the total number of CEO press coverage divided by the total number of the firm press coverage. CEO overconfidence equals 1 if the CEO has options more than 67% in the money at least two times during his or her tenure, 0 otherwise. Board Independence is the ratio of independent directors to total directors. Size is the natural log of the total assets. ROA is the return on assets. PPE is the natural log of the total Property, Plant and Equipment. Leverage is the ratio of long-term debt to total capital. Market to Book is the ratio of market capitalization to total book value. Negative Equity equals 1 if total assets is less than total liabilities.
(1) (2) (3) (4) (5)
VARIABLES N mean SD min max
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Table 1 (Continued)
Panel B: Pearson Correlations
This table provides the correlation data and the significance of each correlation for the cost of debt, CEO reputation, CEO Overconfidence,
Board independence and other firm specific variables.
4.2 Multivariate testing results
To estimate the effects of CEO reputation on the cost of debt and the moderator variables effects on this relation, OLS regression is conducted. Before the analysis, the outliers in the data are trimmed and the Breusch-Pagan test for heteroskedasticity is conducted. The probability of Chi square is 0.3043, which is > 0.10, therefore the test suggests the possible presence of heteroskedasticity in the models. To deal with this problem, heteroskedasticity-robust standard errors are used in the analysis. Furthermore, the year and industry dummy variables are included to control for possible time and industry effects. Table 2 provides the regression results of the regression models specified in chapter 3.
4.2.1 Tests of hypotheses 1a and 1b. Table 2 presents the coefficient estimates and the
robust standard errors are in the parentheses for the OLS regression of the full sample of 2,203 firm-years. As shown in column 1 of Table 2 using Eq. (1), CEO reputation has a negative sign and is significant at 10 percent, with β1 = -0.0001, t-value = -1.70, which is consistent with hypothesis 1a that under efficient contracting CEO reputation will decrease the cost of debt. In terms of the control variables, the variables; firm size, with β1 = 0.0071, t-value = 3.39, and PPE, with β1 = -0.0068, t-value = -4.05, are significant. The control variables profitability, current ratio, leverage, market to book and negative equity are insignificant, suggesting that these variables do not influence the cost of debt, which is inconsistent with expectations and prior results.
4.2.2 Tests of hypothesis 2. For the test of hypothesis 2, the results are shown in column
2 of Table 2 using Eq. (2). With the interaction term, CEO Reputation*CEO Overconfidence, the coefficient of CEO reputation remains negative but becomes insignificant. The interaction term,
CEO Reputation*CEO Overconfidence, is significant at 1 percent, with β1 = 0.0006, tvalue =
-3.51. When CEO overconfidence is 0 then the effect of the interaction term is 0.113 – 0.0000578
CEOreputation and when CEO overconfidence is 1 then the effect of the interaction term is
0.11207 – 0.0006928 CEOreputation. When CEO overconfidence is high, the interaction term is strengthening the impact of CEO reputation under the efficient contracting, which is the opposite of the predictions. Therefore, the results do not support hypothesis 2.
4.2.3 Tests of hypothesis 3. For the test of hypothesis 3, the results are shown in column
3 of Table 2 using Eq. (3). With the interaction term, CEOreputation*Boardindependence, the coefficient estimates for CEO reputation is negative and significant at 5 percent with β1 = -0.0006, t-value = -2.16. The interaction term, CEOreputation*Boardindependence, is also significant at 10 percent, with β1 = 0.0007, t-value = 1.96. The effect of the interaction term is 0.112 –
0.000624*CEOreputation – 0.00277*Boardindependence +
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Table 2 Regression Results
VARIABLES Dependent variable = cost of debt
(1) (2) (3)
Model 1 Model 2 Model 3
CEO Reputation -0.0000733* -0.0000578 -0.000624** (0.0000431) (0.0000393) (0.000289) CEO Overconfidence -0.00093 (0.00131) CEOreputation*CEOoverconfidence -0.000635*** (0.000181) Board Independence -0.00277 (0.00643) CEOreputation*Boardindependence 0.000718* (0.000367) Firm Size 0.00714*** 0.00720*** 0.00723*** (0.00211) (0.00213) (0.00211) ROA 0.0153 0.0172* 0.0153 (0.00966) (0.00975) (0.00964) PPE -0.00679*** -0.00698*** -0.00686*** (0.00168) (0.00170) (0.00168) Current Ratio 0.000813 0.000843 0.000780 (0.000942) (0.000942) (0.000942) Leverage -0.00551 -0.00598 -0.00534 (0.00443) (0.00445) (0.00440)
Market to Book -6.63e-06 -7.49e-06 -6.48e-06
(1.15e-05) (1.16e-05) (1.15e-05)
Negative Equity 0.00305 0.00306 0.00298 (0.00455) (0.00457) (0.00454) Constant 0.110*** 0.113*** 0.112*** (0.0142) (0.0144) (0.0145) Observations 2,195 2,195 2,195 R-squared 0.370 0.373 0.371
Industry dummies YES YES YES
Year dummies YES YES YES
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4.3 Robustness and selection bias checks
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Table 3 Robustness Check (Propensity Score Matching)
VARIABLES Dependent variable = cost of debt
(1) (2) (3)
Model 1 Model 2 Model 3
CEO Reputation -0.000128* -0.000132* -0.000921*** (0.00006.97) (0.0000701) (0.000250) CEO Overconfidence 0.0008906 (0.0019258) CEOreputation*CEOoverconfidence 0.000309 (0.000630) Board Independence -0.00385 (0.00928) CEOreputation*BoardIndependence 0.00106*** (0.000366) Firm Size 0.00342 0.00328 0.00370 (0.00321) (0.00326) (0.00327) ROA 0.0314* 0.0298* 0.0309* (0.0161) (0.0160) (0.0160) PPE -0.00549** -0.00527** -0.00567** (0.00262) (0.00268) (0.00263) Current Ratio 0.000623 0.000543 0.000602 (0.00142) (0.00146) (0.00142) Leverage 0.00206 0.00197 0.00207 (0.00730) (0.00727) (0.00718)
Market to Book -6.91e-06 -6.06e-06 -6.80e-06
(1.69e-05) (1.71e-05) (1.70e-05)
Negative Equity -0.0140 -0.0136 -0.0139 (0.0147) (0.0145) (0.0146) Constant 0.142*** 0.140*** 0.144*** (0.0198) (0.0198) (0.0199) Observations 918 918 918 R-squared 0.356 0.356 0.358
Industry YES YES YES
Year YES YES YES
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Table 4 Selection Bias Check
(1) (2) (3)
VARIABLES Model 1 Model 2 Model 3
CEO Reputation -0.0000749* -0.0000594 -0.000627** (0.0000440) (0.0000402) (0.000288) CEO Overconfidence -0.000947 (0.00129) CEOreputation*CEOoverconfidence -0.000633*** (0.000181) Board Independence -0.00286 (0.00648) CEOreputation*BoardIndependence 0.000720** (0.000365) Firm Size 0.00533 0.00554 0.00523 (0.0106) (0.0106) (0.0106) ROA -0.0126 -0.00840 -0.0155 (0.158) (0.158) (0.159) PPE 0.00302 0.00203 0.00398 (0.0560) (0.0560) (0.0562) Current Ratio -0.00238 -0.00209 -0.00275 (0.0182) (0.0182) (0.0183) Leverage -0.0138 -0.0136 -0.0145 (0.0476) (0.0476) (0.0478)
Market to Book 9.99e-05 9.04e-05 0.000111
(0.000607) (0.000607) (0.000610) Negative Equity -0.00402 -0.00343 -0.00483 (0.0409) (0.0409) (0.0411) λ -7.448329 -6.841799 -8.227577 (42.44985) (42.46184) (42.62636) Constant 5.574 5.132 6.147 (31.14) (31.14) (31.27) Observations 2,195 2,195 2,195 R-squared 0.370 0.373 0.371
Industry YES YES YES
Year YES YES YES
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5. Discussion and conclusion
Prior research proposed that the costs and terms of a debt are affected by asymmetric information and agency costs (e.g. Rajan and Winton, 1995). Strahan (1999) for example finds that firms facing more risks have higher cost of debt, or when firms have more predictable earnings they can get more favorable debt terms (Hasan et al., 2012). Previous literature studied the effects of managerial characteristics on an organization and some argue that the managerial top, the CEO, affects the performance and reputation of a firm (e.g. Gaines-Ross, 2000; Francis et al., 2008; Graffin et al., 2012). Oliver (2005) states that characteristics of individual managers can affect a firm’s financial leverage which is explained by the UET in the study of the behavioral finance. The UET suggests that the more complex the decisions are to be made, the more important the characteristics of the decision-makers are (Hambrick and Mason, 1984). Academics argue that CEO reputation, as other apparent characteristics of executives, serves as a signal for the firm’s potential and performance; and affects the firm’s performance and reputation (Gaines-Ross, 2000; Certo, 2003; Graffin et al., 2012). However, there are two contracting views; (i) efficient contracting versus (ii) rent extraction. According to the efficient contracting perspective, well-regarded CEO’s are likely to avoid actions that involve opportunistic behavior (Fama, 1980), and proposes a positive effect of CEO reputation on the organization’s performance. On the contrary, according to the rent extraction perspective, CEO’s overemphasize their personal career improvement, and consequently may involve into actions to meet the increasing performance expectations (Francis et al., 2008), such as abusive earnings management (Dechow et al., 1996; Francis et al., 2008). Rent extraction proposes a negative effect of CEO reputation on the organization’s performance (Malmendier and Tate, 2009). To extend the understanding of the effects of CEO reputation, the present study examines the effect of CEO reputation on the cost of debt and whether CEO overconfidence and board independence have a moderating effect on this relation.
24
Pittman and Fortin (2004), as they reported a positive correlation between the measurements of their firm size and interest rate.
Second, the findings indicate that CEO overconfidence has a moderating effect on the relation between CEO reputation and the cost of debt, which is consistent with the UET. However, it is inconsistent with the expectation of this study. The results indicate that CEO overconfidence will strengthen the relation between CEO reputation and the cost of debt under the efficient contracting hypothesis, while the expectation is that CEO overconfidence will increase the cost of debt, thereby weakening the effect under the efficient contracting perspective. The unexpected finding
is however consistent with Olsen et al. (2014), they indicate that narcissistic CEO’s3 pursue
operational strategies to increase earnings rather than to employ accrual-related or accounting-based manipulations (rent extraction), since it can destroy one’s reputation especially when it escalates to fraudulent levels. Olsen et al.’s (2014) finding is reinforcing the efficient contracting perspective. Furthermore, most of the CEO’s have a significant portion of wealth tied to the firm (Healy and Whalen, 1999). They have direct incentives to increase firm performance for their own good.
Third, the results show a moderating effect of the board independence on the relation between CEO reputation and the cost of debt. However, the results suggest that board independence weakens the impact of CEO reputation on the cost of debt under the efficient contracting perspective, indicating that when board independence increases, the negative relation between CEO reputation and the cost of debt becomes weaker. The result is inconsistent with the expectations of the study and previous findings, such as Anderson et al.’s study (2004), they find that board independence is associated with significantly lower debt financing costs. As independent board members substitute a portion of creditor’s monitoring activities, the monitoring costs of creditors should be lowered, leading to a lower cost of debt. On the other hand, the result is consistent with Bradley and Chen (2014), as they found that board independence increases the cost of debt when the conflict of interests between shareholders and bondholders is severe (agency cost of debt). Bondholders “free ride” on some monitoring benefits of independent directors for shareholders when the interests of shareholders and bondholders converge, however other potential actions an independent board takes can harm the bondholders when the interests of the
two stakeholders diverge or are in conflict (Jensen and Meckling, 1976).
To summarize, the results show that reputed CEO’s are associated with a lower cost of debt, which is consistent with the efficient contracting perspective. Further, the study examines whether CEO overconfidence and board independence have a moderating effect on the relation between CEO reputation and the cost of debt. Findings show that CEO overconfidence has a significant effect on this relation, suggesting that the moderating effect of CEO overconfidence further decreases the cost of debt under the efficient contracting hypothesis. The results also provide evidence that board
3 Although narcissism and hubris (overconfidence) are two distinct constructs, Hayward and
25
independence moderates this relation by weakening the impact of CEO reputation on the cost of debt under the efficient contracting hypothesis, indicating that board independence increases the cost of debt. The results indicate that CEO reputation and the moderation effect of CEO overconfidence are associated with a lower cost of debt financing and board independence with higher cost of debt financing. The results suggest that CEO reputation, CEO overconfidence and the board of directors are important elements in the financial accounting process. The findings further suggest that creditors are concerned with governance mechanisms that could limit managerial opportunism.
26
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