Hostname: page-component-78c5997874-ndw9j Total loading time: 0 Render date: 2024-11-15T04:59:12.774Z Has data issue: false hasContentIssue false
  • English
  • Français

Executive Pay Disparity and the Cost of Equity Capital

Published online by Cambridge University Press:  13 June 2013

Zhihong Chen ,
Yuan Huang  and
K. C. John Wei
Zhihong Chen
Affiliation:
chenzhh@cityu.edu.hk, College of Business, City University of Hong Kong, Tat Chee Ave, Kowloon, Hong Kong
Yuan Huang
Affiliation:
afyhuang@polyu.edu.hk, School of Accounting and Finance, Hong Kong Polytechnic University, Hunghom, Kowloon, Hong Kong
K. C. John Wei
Affiliation:
johnwei@ust.hk, School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong
Get access Rights & Permissions [Opens in a new window]

Abstract

Executive pay disparity, as measured by chief executive officer (CEO) pay slice (CPS), is positively associated with the implied cost of equity, even after controlling for other determinants of the cost of equity. The difference in the cost of equity can explain 43% of the difference in the valuation effect attributable to CPS reported by Bebchuk, Cremers, and Peyer (2011). Further analysis shows that the positive association is stronger when agency problems of free cash flow are more severe and when CEO succession planning is more important. Our evidence suggests that a large CPS is associated with CEO entrenchment and high succession risk.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 48 , Issue 3 , June 2013 , pp. 849 - 885
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2013 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Albuquerque, R., and Wang, N.. “Agency Conflicts, Investment, and Asset Pricing.” Journal of Finance, 63 (2008), 1–40.CrossRefGoogle Scholar
Ashbaugh-Skaife, H.; Collins, D. W.; and LaFond, R.. “Corporate Governance, Risk and Cost of Equity Capital.” Working Paper, University of Wisconsin at Madison and University of Iowa (2006).Google Scholar
Bebchuk, L. A., and Cohen, A.. “The Costs of Entrenched Boards.” Journal of Financial Economics, 78 (2005), 409–433.CrossRefGoogle Scholar
Bebchuk, L. A.; Cohen, A.; and Ferrell, A.. “What Matters in Corporate Governance?” Review of Financial Studies, 22 (2009), 783–827.CrossRefGoogle Scholar
Bebchuk, L. A.; Cremers, M.; and Peyer, U.. “The CEO Pay Slice.” Journal of Financial Economics, 102 (2011), 199–221.CrossRefGoogle Scholar
Bebchuk, L. A., and Fried, J. M.. “Executive Compensation as an Agency Problem.” Journal of Economic Perspectives, 17 (2003), 71–92.CrossRefGoogle Scholar
Bowen, R. M.; Rajgopal, S.; and Venkatachalam, M.. “Accounting Discretion, Corporate Governance, and Firm Performance.” Contemporary Accounting Research, 25 (2008), 351–405.CrossRefGoogle Scholar
Bower, J. L. “Solve the Succession Crisis by Growing Inside-Outside Leaders.” Harvard Business Review (2007), 91–96.Google ScholarPubMed
Brav, A.; Lehavy, R.; and Michaely, R.. “Using Expectations to Test Asset Pricing Models.” Financial Management, 34 (2005), 31–64.CrossRefGoogle Scholar
Brickley, J. A. “Empirical Research on CEO Turnover and Firm Performance: A Discussion.” Journal of Accounting and Economics, 36 (2003), 227–233.CrossRefGoogle Scholar
Bushman, R.; Dai, Z.; and Wang, X.. “Risk and CEO Turnover.” Journal of Financial Economics, 96 (2010), 381–398.CrossRefGoogle Scholar
Campbell, J. Y. “A Variance Decomposition for Stock Returns.” Economic Journal, 101 (1991), 157–179.CrossRefGoogle Scholar
Chen, K. C. W.; Chen, Z.; and Wei, K. C. J.. “Legal Protection of Investors, Corporate Governance, and the Cost of Equity Capital.” Journal of Corporate Finance, 15 (2009), 273–289.CrossRefGoogle Scholar
Chen, K. C. W.; Chen, Z.; and Wei, K. C. J.. “Agency Costs of Free Cash Flow and the Effect of Shareholder Rights on the Implied Cost of Equity Capital.” Journal of Financial and Quantitative Analysis, 46 (2011), 171–207.CrossRefGoogle Scholar
Clayton, M. C.; Hartzell, J. C.; and Rosenberg, J.. “The Impact of CEO Turnover on Equity Volatility.” Journal of Business, 78 (2005), 1779–1808.CrossRefGoogle Scholar
Cooper, M. J.; Gulen, H.; and Rau, P. R.. “Performance for Pay? The Relationship between CEO Incentive Compensation and Future Stock Price Performance.” Working Paper, University of Utah (2009).Google Scholar
Coyne, K. P., and Coyne, E. J.. “Surviving Your New CEO.” Harvard Business Review (2007), 62–69.Google ScholarPubMed
Cremers, M., and Grinstein, Y.. “Does the Market for CEO Talent Explain Controversial CEO Pay Practices?” Working Paper, Yale School of Management and Cornell University (2011).CrossRefGoogle Scholar
Dechow, P. M., and Dichev, I. D.. “The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors.” Accounting Review, 77 (2002), 35–59.CrossRefGoogle Scholar
Dhaliwal, D.; Krull, L.; Li, O.; and Moser, W.. “Dividend Taxes and Implied Cost of Equity Capital.” Journal of Accounting Research, 43 (2005), 675–708.CrossRefGoogle Scholar
Easton, P. D., and Monahan, S. J.. “An Evaluation of Accounting-Based Measures of Expected Returns.” Accounting Review, 80 (2005), 501–538.CrossRefGoogle Scholar
Easton, P. D., and Sommers, G.. “Effect of Analysts’ Optimism on Estimates of the Expected Rate of Return Implied by Earnings Forecasts.” Journal of Accounting Research, 45 (2007), 983–1015.CrossRefGoogle Scholar
Elton, J. “Expected Return, Realized Return, and Asset Pricing Test.” Journal of Finance, 54 (1999), 1199–1220.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “The Cross-Section of Expected Stock Returns.” Journal of Finance, 47 (1992), 427–465.Google Scholar
Fama, E. F., and French, K. R.. “Industry Costs of Equity.” Journal of Financial Economics, 43 (1997), 153–193.CrossRefGoogle Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.CrossRefGoogle Scholar
Ferreira, M. A., and Matos, P.. “The Colors of Investors’ Money: The Role of Institutional Investors around the World.” Journal of Financial Economics, 88 (2008), 499–533.CrossRefGoogle Scholar
Francis, J.; LaFond, R.; Olsson, P.; and Schipper, K.. “Costs of Equity and Earnings Attributes.”Accounting Review, 79 (2004), 976–1010.CrossRefGoogle Scholar
Garmaise, M. J., and Liu, J.. “Corruption, Firm Governance, and the Cost of Capital.” Working Paper, University of California at Los Angeles (2005).CrossRefGoogle Scholar
Gebhardt, W. R.; Lee, C. M. C.; and Swaminathan, B.. “Toward an Implied Cost of Capital.” Journal of Accounting Research, 39 (2001), 135–176.CrossRefGoogle Scholar
Gillan, S., and Starks, L.. “Corporate Governance Proposals and Shareholder Activism: The Role of Institutional Investors.” Journal of Financial Economics, 57 (2000), 275–305.CrossRefGoogle Scholar
Gompers, P. A.; Ishii, J. L.; and Metrick, A.. “Corporate Governance and Equity Prices.” Quarterly Journal of Economics, 118 (2003), 107–155.CrossRefGoogle Scholar
Guay, W. R.; Kothari, S. P.; and Shu, S.. “Properties of Implied Cost of Capital Using Analysts’ Forecasts.” Australian Journal of Management, 36 (2011), 125–149.CrossRefGoogle Scholar
Hail, L., and Leuz, C.. “International Differences in the Cost of Capital: Do Legal Institutions and Securities Regulation Matter?” Journal of Accounting Research, 44 (2006), 485–531.CrossRefGoogle Scholar
Hail, L., and Leuz, C.. “Cost of Capital Effects and Changes in Growth Expectations around U.S. Cross Listings.” Journal of Financial Economics, 93 (2009), 428–454.CrossRefGoogle Scholar
Hanlon, M.; Rajgopal, S.; and Shevlin, T.. “Large Sample Evidence on the Relation between Stock Options and Risk Taking.” Working Paper, University of Michigan and University of Washington (2004).CrossRefGoogle Scholar
Hermalin, B. E., and Weisbach, M. S.. “The Determinants of Board Composition.” RAND Journal of Economics, 19 (1988), 589–606.CrossRefGoogle Scholar
Ho, V., and Epstein, B.. “Explorations in Executive Compensation, Key Considerations in Executive Pay.” RiskMetrics Report (2008).Google Scholar
Huson, M. R.; Malatesta, P. H.; and Parrino, R.. “Managerial Succession and Firm Performance.” Journal of Financial Economics, 74 (2004), 237–275.CrossRefGoogle Scholar
Jensen, M. C. “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.” AmericanEconomic Review, 76 (1986), 323–329.Google Scholar
Jensen, M. C., and Meckling, W. H.. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics, 3 (1976), 305–360.CrossRefGoogle Scholar
Kale, J. R.; Reis, E.; and Venkateswaran, A.. “Rank-Order Tournaments and Incentive Alignment: The Effect on Firm Performance.” Journal of Finance, 64 (2009), 1479–1512.CrossRefGoogle Scholar
Klein, A. “Audit Committee, Board of Director Characteristics, and Earnings Management.” Journal of Accounting and Economics, 33 (2002), 375–400.CrossRefGoogle Scholar
Lang, L. H. P.; Stulz, R. M.; and Walkling, R. A.. “A Test of the Free Cash Flow Hypothesis: The Case of Bidder Returns.” Journal of Financial Economics, 29 (1991), 315–336.CrossRefGoogle Scholar
Lazear, E. P., and Rosen, S.. “Rank-Order Tournaments as Optimum Labor Contracts.” Journal of Political Economy, 89 (1981), 841–864.CrossRefGoogle Scholar
Lee, C. M. C.; So, E. C.; and Wang, C. C. Y.. “Evaluating Implied Cost of Capital Estimates.” Working Paper, Stanford University (2010).CrossRefGoogle Scholar
Lombardo, D., and Pagano, M.. “Law and Equity Markets: A Simple Model.” In Corporate Governance Regimes: Convergence and Diversity, McCahery, J., Moerland, P., Raaijmakers, T., and Renneboog, L., eds. London, UK: Oxford University Press (2002).Google Scholar
Masulis, R. W., and Mobbs, S.. “Are All Inside Directors the Same? Evidence from the External Directorship Market.” Journal of Finance, 66 (2011), 823–872.CrossRefGoogle Scholar
McCool, J. D. “SEC Puts CEO Succession Center Stage.” Business Week (Dec. 1, 2009).Google Scholar
Merton, R. C. “A Simple Model of Capital Market Equilibrium with Incomplete Information.” Journal of Finance, 42 (1987), 483–510.CrossRefGoogle Scholar
Modigliani, F., and Miller, M. H.. “The Cost of Capital, Corporation Finance, and the Theory of Investment.” American Economic Review, 48 (1958), 261–297.Google Scholar
Mohanram, P., and Gode, D.. “Evaluating Implied Cost of Equity Estimates after Removing Predictable Analyst Forecast Errors.” Working Paper, University of Toronto and Columbia University (2011).Google Scholar
Moody, . “Special Comment: U.S. Executive Pay Structure and Metrics” (2006).Google Scholar
Morck, R.; Shleifer, A.; and Vishny, R. W.. “Management Ownership and Market Valuation: AnEmpirical Analysis.” Journal of Financial Economics, 20 (1988), 293–315.CrossRefGoogle Scholar
Murphy, K. J. “Executive Compensation.” In Handbook of Labor Economics, Ashenfelter, O. and Card, D., eds. Amsterdam: Elsevier (1999), 2485–2563.Google Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.CrossRefGoogle Scholar
Ogneva, M.; Subramanyam, K. R.; and Raghunandan, K.. “Internal Control Weakness and Cost of Equity: Evidence from SOX Section 404 Disclosure.” Accounting Review, 82 (2007), 1255–1297.CrossRefGoogle Scholar
Parrino, R. “CEO Turnover and Outside Succession: A Cross-Sectional Analysis.” Journal of Financial Economics, 46 (1997), 165–197.CrossRefGoogle Scholar
Parrino, R.; Sias, R. W.; and Starks, L. T.. “Voting with Their Feet: Institutional Ownership Changes around Forced CEO Turnover.” Journal of Financial Economics, 68 (2003), 3–46.CrossRefGoogle Scholar
Pástor, L.; Sinha, M.; and Swaminathan, B.. “Estimating the Intertemporal Risk-Return Tradeoff Using the Implied Cost of Capital.” Journal of Finance, 63 (2008), 2859–2897.CrossRefGoogle Scholar
Petersen, M. A. “Estimating Standard Errors in Finance Panel Data Sets: Comparing Approaches.” Review of Financial Studies, 22 (2009), 435–480.CrossRefGoogle Scholar
Raheja, C. G. “Determinants of Board Size and Composition: A Theory of Corporate Boards.” Journal of Financial and Quantitative Analysis, 40 (2005), 283–306.CrossRefGoogle Scholar
Rajan, R. G., and Wulf, J.. “The Flattening Firm: Evidence from Panel Data on the Changing Nature of Corporate Hierarchies.” Review of Economics and Statistics, 88 (2006), 759–773.CrossRefGoogle Scholar
Schwarz, M., and Severinov, S.. “Investment Tournaments: When Should a Rational Agent Put All Eggs in One Basket?” Journal of Labor Economics, 28 (2010), 893–922.CrossRefGoogle Scholar
Shen, W., and Cannella, A. A. Jr. “Will Succession Planning Increase Shareholder Wealth? Evidence from Investor Reaction to Relay CEO Successions.” Strategic Management Journal, 24 (2003), 191–198.CrossRefGoogle Scholar
Stulz, R. M. “Globalization of Equity Markets and the Cost of Capital.” Working Paper, Ohio State University (1999).CrossRefGoogle Scholar
Taylor, C. R. “Digging for Golden Carrots: An Analysis of Research Tournament.” American Economic Review, 85 (1995), 872–890.Google Scholar
Vancil, R. Passing the Baton. Boston, MA: Harvard University Press (1987).Google Scholar
Warner, J. B.; Watts, R. L.; and Wruck, K. H.. “Stock Prices and Top Management Changes.” Journal of Financial Economics, 88 (1988), 461–492.CrossRefGoogle Scholar
Yermack, D. “Higher Market Valuation of Companies with a Small Board of Directors.” Journal of Financial Economics, 40 (1996), 185–211.CrossRefGoogle Scholar
Zhang, Y., and Rajagopalan, N.. “When the Known Devil Is Better Than an Unknown God: An Empirical Study of the Antecedents and Consequences of Relay CEO Successions.” Academy of Management, 47 (2004), 483–500.CrossRefGoogle Scholar