Theories based on the premise that leverage reduces managerial discretion implicitly assume that managers will not issue the optimal amount ol debt without pressure from a ‘disciplining’ force. Our results support such predictions. We find evidence that leverage is affected by the degree of managerial entrenchment and most of the results
indicate that entrenched managers seek to avoid debt. We found that leverage is lower when the CEO has had a long tenure in office, has weak stock and compensation incentives, and does not face strong monitoring from the board or important stockholders.
But these results are also open to other interpretations. For example, the positive association between leverage and fractional CEO stock ownership is consistent with the theory that managers use leverage to inflate the voting power of their equity. The overall tenor of our results points to CEOs being hesitant to take on as much leverage as shareholders would like. Although we found evidence that this problem can be alleviated by extreme threats to the CEO’s security, such as a takeover battle or the forced replacement of the CEO, shareholders and corporate governance experts are likely to prefer less extreme solutions.
Our evidence uncovered two less extreme mechanisms that are effective in reducing the problem. Providing compensation to the CEO through stock option grants encourages an increase in leverage because the value of these options is increased by raising the expected value and the risk level of the company. Alternatively, increasing the monitoring of the CEO by large stockholders and by adding representatives of such holders to the board of directors also results in the CEO increasing the business’ leverage. Thus, more effective corporate governance can result in CEOs moving closer to the leverage levels desired by shareholders.