Title

The relationship between underinvestment, overinvestment and CEO's compensation

Department/School

Finance

Date of this version

2012

Document Type

Article

Keywords

Compensation, investment, entrenchment, incentives, firm performance

Abstract

This research separates out the incentive and entrenchment effects of executive pay and uses it to test if the agency cost is that of underinvestment or overinvestment. I find that investments increase with dollar value of stock and options owned by the CEO but decrease with percentage of shares owned by the CEO. These results are robust to alternate measures of investments such as R&D, acquisitions, and change in assets. It appears that the positive relationship between investment and percentage of stocks owned by the CEO, as observed in the literature, is because of the omitted variable of dollar value of stock and options. I also find that the increases in dollar value of stock and options owned by the CEO reduces agency costs; while increases in percentage of stocks owned by the CEO increases entrenchment. These results are robust to endogeniety and a battery of relevant tests. This research concludes that, for the average firm, the agency cost is that of underinvestment, while the concerns about overinvestment are overstated.

Published in

Review of Pacific Basin Financial Markets and Policies

Citation/Other Information

15(3), 1250014-1 - 1250014-26.