Internal capital allocation and executive compensation

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Date

2005

Authors

Yong, Li

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Abstract

This research examines the connection between executive compensation and within-firm capital allocation decisions by multi-segment firms. Although previous studies have considered the asymmetric information between a firm’s headquarter and its divisions, they have not explicitly addressed the issue of how internal capital allocation decisions are affected by the CEO’s own incentives. In this study, I focus on incentives that derive from the CEO’s compensation. First, I show that a conglomerate CEO’s compensation is related to the weighted average pay in industries associated with the firm’s segments. Next, I document that executives of multi-segment firms appear to respond strongly to compensation incentives when allocating funds across segments. Specifically, I find that firms invest more in segments associated with higher levels of executive compensation, and that they are more likely to add (drop) segments with higher (lower) pay levels. Importantly, the effects of compensation remain even after controlling for economic factors that have previously been documented to affect firms’ investment decisions (e.g., past performance, size, growth opportunity, and industry). Furthermore, I present evidence that following active reallocations, CEO compensation does go up in subsequent years. In particular, firms engaging in segment restructuring activities experience faster growth in CEO compensation relative to the market. In addition, I find that incentives created by executive stock options lead CEOs to invest more in riskier industries and industries with better past performance. Overall, my results suggest that both the level and structure of executive compensation affect firms’ internal capital allocations. This conclusion is robust to various sensitivity checks.

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