Can the agency costs of debt and equity explain the changes in executive compensation during the 1990s? Stephen Bryan 1 , Robert Nash 2 , Ajay Patel * Babcock Graduate School of Management, Wake Forest University, Winston-Salem, NC 27109-7424, United States Received 24 April 2005; received in revised form 25 August 2005; accepted 6 September 2005 Available online 19 October 2005 Abstract Contracting theory predicts that greater equity-related compensation will decrease the agency problems of equity but may exacerbate the agency problems of debt. We present evidence that the agency costs of debt may have declined during the 1990s. Specifically, changes in the financial characteristics of our sample firms suggest that underinvestment, asset substitution, and financial distress became less likely. Furthermore, agency costs of equity increased during the 1990s, primarily because firms became more difficult to monitor. Together, the findings provide an explanation for why more firms used option-based compensation in the latter 1990s, and why the proportion of options in compensation structure increased throughout the decade of the 1990s. D 2005 Elsevier B.V. All rights reserved. JEL classification: G34; J33; M52 Keywords: Agency costs; Executive compensation; Stock options 1. Introduction Financial economists have long suggested that firms design management compensation contracts to mitigate agency conflicts. In this paper, we examine how the agency problems of debt and equity affect the firm’s compensation structure (i.e., relative amount of option-based and cash-based compensation). Furthermore, through our analysis of both types of agency costs, we provide an explanation for why more firms used option-based compensation and why the relative use of option-based compensation increased during the 1990s. 0929-1199/$ - see front matter D 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jcorpfin.2005.09.001 * Corresponding author. Tel.: +1 336 758 5575; fax: +1 336 758 4514. E-mail addresses: Stephen.Bryan@mba.wfu.edu (S. Bryan), Rob.Nash@mba.wfu.edu (R. Nash), Ajay.Patel@mba.wfu.edu (A. Patel). 1 Tel.: +1 336 758 3671; fax: +1 336 758 4514. 2 Tel.: +1 336 758 4166; fax: +1 336 758 4514. Journal of Corporate Finance 12 (2006) 516 – 535 www.elsevier.com/locate/jcorpfin