Executive Pay Disparity and the Cost of Equity Capital

The following post comes to us from Zhihong Chen of the Department of Accountancy at City University of Hong Kong, Yuan Huang of the School of Accounting and Finance at Hong Kong Polytechnic University, and K.C. John Wei, Professor of Finance at Hong Kong University of Science & Technology (HKUST).

In our paper, Executive Pay Disparity and the Cost of Equity Capital, forthcoming in the Journal of Financial and Quantitative Analysis, we investigate the association between executive pay disparity and the cost of equity capital. Understanding the association is important because the cost of capital is one of the key considerations for managers in their capital budgeting and corporate financing decisions. In fact, the cost of capital is a more direct yardstick of corporate investment and financing decisions than firm valuation. A higher cost of capital means fewer positive net present value (NPV) projects, leading to fewer growth opportunities. In addition, the cost of capital summarizes an investor’s risk-return tradeoff in his resource allocation decision (Pástor, Sinha, and Swaminathan (2008)).

In general, there are two perspectives on executive pay disparity. The tournament perspective views the large pay gap between the CEO and other executives as the prize for a tournament in which players compete for the CEO position (Lazear and Rosen (1981); Kale, Reis, and Venkateswaran (2009)). A large pay disparity motivates non-CEO senior executives to work hard and to invest in firm-specific human capital. This, in turn, helps build a large pool of skilled internal candidates for the CEO position. The availability of skilled internal candidates not only reduces the entrenchment of the incumbent CEO by increasing the bargaining power of the board, but also reduces CEO succession risk. Therefore, this perspective predicts a negative association between executive pay disparity and the cost of capital.

On the other hand, the managerial power perspective (Bebchuk and Fried (2003)) suggests that pay reflects the bargaining power of executives and therefore a large pay disparity between the CEO and other senior executives indicates an entrenched CEO. An entrenched CEO is associated with a more severe agency problem during his tenure (Bebchuk, Cremers, and Peyer (2011)). In addition, an entrenched CEO may obstruct succession planning, especially the grooming of internal successor candidates, to further entrench himself (Rajan and Wulf (2006); Masulis and Mobbs (2011)). This leads to a high succession risk. As a result, the managerial power perspective predicts a positive association between executive pay disparity and the cost of capital.

We find a significant and positive association between executive pay disparity and the ex ante cost of equity capital implied in stock prices and analysts’ earnings forecasts. The association is robust to alternative model specifications, estimates of cost of equity, and proxies for executive pay disparity. A series of robustness tests suggest that the positive association is not likely due to biases associated with the endogeneity of executive pay disparity. Furthermore, the positive association is more pronounced the higher the level of severity of the agency problem of free cash flows faced by the firm. The positive association is also more pronounced the more likely the incumbent CEO is to leave in the near future and the more difficult it is to find a suitable successor.

These findings also hold even when residual executive pay disparity is used in the analysis, where the residual comes from a regression of pay disparity on 14 corporate governance-related variables that potentially affect the cost of equity. Finally, a larger change in stock return volatility around CEO turnover events is also associated with a larger executive pay disparity before CEO turnovers. In sum, the evidence is consistent with the hypothesis that shareholders view a large pay disparity as a symptom of CEO entrenchment, which implies not only more opportunistic behavior during his tenure but also higher succession risk when he leaves.

We make several contributions to the emerging literature on executive pay disparity. First, to the best of our knowledge, we are the first to provide large sample evidence on the association between executive pay disparity and the cost of equity. Our results are consistent with those of Bebchuk et al. (2011), but are inconsistent with those of Kale et al. (2009). In particular, Bebchuk et al. (2011) find that executive pay disparity is associated with lower firm value and lower future cash flows. We complement their study by showing that investors also charge a higher discount rate for firms with a large pay disparity and that a significant portion of the firm valuation effect attributable to executive pay disparity as documented by them is in fact due to the cost of equity effect. Our study is also related to the one by Cooper et al. (2009), in which they find a negative relation between executive pay and future realized returns. Their study suggests that investors do not fully incorporate the information implied in executive pay into stock prices. We show that investors do realize that excessive CEO pay relative to the pays of other senior executives can be a symptom of CEO entrenchment and an indication of succession risk. In other words, investors do incorporate this information into their resource allocation decisions.

Second, our study enhances our understanding of the implications of executive pay disparity. Bebchuk et al. (2011) provide evidence that a large executive pay disparity is associated with various opportunistic behavior of the CEO during his tenure. Consistent with their findings, our study indicates that shareholders discount the cash flows of firms with a large executive pay disparity more when the agency problem of free cash flows is more severe. Furthermore, our results suggest that a large executive pay disparity is associated with poor CEO succession planning and high succession risk, which is also incorporated into shareholders’ resource allocation decisions. Our evidence suggests that poor CEO succession planning and high succession risk can explain the findings of Bebchuk et al. (2011) that the incumbent CEO is less likely to be replaced for poor performance.

Finally, our paper also contributes to our understanding of the determinants of the cost of equity, a key variable in a firm’s financing and capital budgeting decisions. Our paper is related to recent studies on the effect of corporate governance on the cost of equity in general (Ashbaugh-Skaife et al. (2006); Hail and Leuz (2006, 2009); Chen et al. (2009, 2011)). In particular, we find that executive pay disparity is positively associated with the cost of equity even after controlling for the influence of governance-related variables on CEO pay disparity. This evidence is also in line with the notion that executive pay disparity captures additional information beyond the agency problem (Bebchuk et al. (2011)).

The full paper is available for download here.

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