Abstract

This paper provides empirical validation of the theoretical relationship between firm performance and CEO compensation. The rational behavior hypothesis is that the “CEO that is paid more works harder (and succeeds) to improve the financial performance of the corporation that he/she leads. To test this relationship as our hypothesis, we collected information of firms and CEO compensation from the COMPUSTAT and EXECUCOMP data bases. Of the SP500 firms, we selected 276 firms with complete data in the 10-year period from 1995 to 2004. We estimate three measures/indicators of firm performance: Return On Equity (ROE), Return On Equity Average (ROE_AVG), and Economic Value Added (EVA). CEO compensation is measured by six categories: CEO Salary, Restricted Stock Grants, Options Awarded, Bonus, Long-Term Incentive Payouts (LTIP), and Total CEO Compensation. There are over 40,000 observations of both CEO compensation and corporate profit returns in the important large corporations in a period when media, analysts, and university research community were calling for CEOs to get with it. After controlling for fixed effects (macroeconomic and specific industry conditions) of the six types of CEO compensation, we find that only cash bonus has had a significant positive effect on firm performance. A one million dollar increase in bonus—an increase of 83.68% (based on the sample average of 1.195 million dollars) - was associated with a 1.15% increase in Average ROE in the fixed effects model or 1.03% increase in the random effects model. However, once we control for endogeneity of CEO compensation, i.e. that it was simultaneously determined with performance, none of the six payment types had significant effects on firms’ performance. This finding suggests a rethinking of the role of the CEO compensation as an incentive for improving corporate performance, i.e. can the CEO actually affect the annual profit of firms of this scale. The finding, interpretations and conclusions expressed herein are those of the authors. We greatly appreciate the comments and feedback provided by our colleagues at Yale School of Management (especially Professor Paul MacAvoy and Dean Ira Millstein) and Brown University All remaining errors are our own. Email addresses: dennisWmichaud@gmail.com (Dennis Michaud), ygai@babson.edu (Yunwei Gai). Dedication: This paper is dedicated to Professor Paul W. MacAvoy. Throughout this project his suggestions, comments, advice, and encouragement have been tireless. Paul is the former dean of the Simon and Yale Schools of Management and in our opinion, the dean of corporate governance research. As a teacher, scholar, and corporate director, Paul has been a strong advocate for enhanced corporate governance and shareholder rights. We are all in his debt.

Full Text
Published version (Free)

Talk to us

Join us for a 30 min session where you can share your feedback and ask us any queries you have

Schedule a call