Introduction of New CEO Incentive Structure and Effects on Firm Policies

Abstract

We investigate the impact of the creation of a new incentive structure for CEOs resulting from firms initiating equity-based compensation (EBC) as a means of paying top executives on firm policy decisions. Contrasting firm stock and operating performance in the period the CEO is compensated with EBC (EBC period) and the period when EBC is not a component of the executive’s pay (No EBC period) leads us to conclude that awarding stock options and restricted shares to executives is not associated with higher firm value. However, firms have higher unsystematic and total risk levels in the EBC period suggesting that awarding equity-based compensation to CEOs influences their risk-taking behavior. While there is no change in R&D expenses and cash ratios there is a decrease in capital expenditures in the EBC period, which is consistent with reduced overinvestment agency costs. Finally, leverage and dividend payout ratios are similar in EBC and No EBC periods implying that EBC does not impact a firm’s financing policy.

Keywords: Equity-based compensation, Executive compensation, Firm performance

JEL Classification: G31, G34