International Journal of Management Vol. 30 No. 2 Part 2 June 2013 649 Cost of Capital as a Moderator of the Effect of Equity- Based Compensation on Risk-Taking by Managers Chan Du University of Massachusetts Dartmouth Agency theory and contract theory predict that compensation contract can be designed to reduce the agency cost of equity and agency cost of debt in terms of risk taking by managers. Prior empirical studies focus on cost of equity effect and ind that equity- based compensation reduces agency cost of equity by providing manager incentives to increase irm's risk. This study takes into account of cost of debt to argue that agency cost of debt as measured by inancial leverage affects the association between equity- based compensation and risk taking by managers. The paper analyzes a sample of 2,017 American irms over the period from 1992 to 2004 by use of the simultaneous equation models, which address the simultaneity of compensation decisions by board of directors and risk taking decisions by managers. The results show that chief executive oficers (CEOs) act differently for irms with different inancial leverage and different types of debt. Speciically, the sensitivity of CEO wealth to stock returns volatility (Vega) has a lower impact on risk taking for debt-inanced irms than all-equity irms, while the sensitivity of CEO wealth to stock price (Delta) has a higher impact on risk taking for debt-inanced irms than all-equity irms, where risk taking by managers is measured as observable risky investment decisions, Research and Development (R&D) investments. The results hold even after controlling for the effects of irm’s size, investment opportunities, surplus cash, and sales growth. The results support the argument that equity-based compensation mitigates agency cost of debt in addition to agency cost of equity in terms of risk taking by managers. Introduction Modern corporations are characterized by a separation of ownership and control. There are two main conlicts of interest within the modern corporation, the conlict of interest between shareholders and managers, and the conlict of interest between shareholders and bondholders. The irst conlict arises when shareholders ind it eficient to delegate decision-making to managers, but managers want to maximize their own beneits instead of those of the shareholders. The alignment of shareholders’ and managers’ interests has become the main task of corporate governance. This conlict may arise in terms of managers’ choice of effort or risk. Shareholders prefer that managers provide effort to improve output. If managers incur a personal cost for providing effort, and that managerial effort is not observable (or inferable) by shareholders, then managers have an opportunity to choose actions that increase beneit that accrue to them only. In addition, managers and shareholders may differ in their attitudes toward risk taking. Relative to shareholders, managers are assumed more risk averse due to human capital risk as well as less diversiied of their wealth portfolios. They may choose to avoid risk-increasing positive NPV