Determinants of capital structure and management compensation: The partial least squares approach

This study addresses two leverage-related issues—the determinants of capital structure choice and how capital structure affects the relationship between firm performance and management compensation. The former is essentially based on Titman and Wessels (1988) and the latter is mainly based on John and John (1993). Both structural equation modeling and partial least squares approaches are employed to investigate the issues.; An integrated framework of determinants of capital structure choice was tested in terms of multiple indicator and multiple cause (MIMIC) model and partial least squares (PLS) method. In MIMIC model, five proposed cause variables of capital structure have significant effect on capital structure while two debt ratios are significant indicators of capital structure. The significant cause variables include the coefficient of variation of rate of return on equity, the percentage change of total assets, the ratio of inventory plus gross plant and equipment to total assets, the ratio of non-debt tax shields to total assets, and the coefficients of variation of operating income. Two significant indicators of capital structure are long-term debt and short-term debt denominated by market value of equity. In addition, the partial least squares method is used to examine the prediction effect of determinants of capital structure on leverage. The result shows that sixteen out of seventeen proposed variables have significant prediction power on capital structure. The long-term debt and short-term debt denominated by market value of equity are significant indicators of capital structure.; Based on John and John's (1993) theoretical work on the relationship between pay-performance sensitivity and capital structure, this study applies PLS approach to test the developed theory. Four hypotheses regarding the contemporaneous response of firm performance on management compensation and how capital structure affects the relationship between firm performance and management compensation are tested. This study found that (1) strong contemporaneous response of management compensation on firm performance exists, (2) large firms have lower pay-performance sensitivity relative to small firms, and (3) firms with convertible debt have higher pay-to-performance sensitivity than that of those without convertible debt.