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I model the joint effects of debt macroeconomic conditions and cash flow cyclicality on risk-shifting behavior and managerial pay-for-performance sensitivity. I show that risk-shifting incentives rise during recessions and that the shareholders can eliminate such adverse incentives by reducing the equity-based compensation in managerial contracts. I also show that this reduction should be larger in highly procyclical firms. Using a sample of U.S. public firms I provide evidence supportive of the model’s predictions. First I find that equity-based incentives are reduced during recessions. Second I show that the magnitude of this effect is increasing in a firm’s cash flow cyclicality. |
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