ROE as a performance measure in performance-vested stock option contracts in China

Abstract

In this paper, we hand-collect the performance measures adopted in performance-vested stock option plans in China. We find that return on equity (ROE) is a widely used performance measure. Different from most of the other performance measures, ROE is affected by the number of shares outstanding. When executive compensation contracts are explicitly tied to ROE performance, in order to avoid the reduction in reported ROE through the issuance of additional common shares (i.e., ROE dilution), managers have an incentive to influence ROE performance through financing decisions. We find that managers are more likely to avoid ROE dilution related to debt-versus-equity choice when their performance-vested stock option plans are explicitly tied to ROE performance and when firms have a high level of access to bank loans. However, there is no such link for firms with a low level of access to bank loans. Our study shows that the association between executive compensation design and corporate financing decisions depends on the accessibility of bank loans, demonstrating the importance of institutional factors in China. The results hold after controlling for potential endogeneity in executive compensation and corporate financing decisions. Our study contributes to both the executive compensation and corporate finance literature.