Abstract Existing theories advocate the exclusive use of equity-like instruments in executive compensation. However, recent empirical studies document the prevalence of debt-like instruments such as pensions. This paper justifies the use of debt as efficient compensation. Inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses and salaries proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also firm value in bankruptcy. Contrary to intuition, granting the manager equal proportions of debt and equity is typically inefficient. In most cases, an equity bias is desired to induce effort. However, if effort is productive in increasing liquidation value, or if bankruptcy is likely, a debt bias can improve effort as well as alleviate the agency costs of debt. The model generates a number of empirical predictions consistent with recent evidence.
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