Agency Costs of Free Cash Flow and the CEO Pay-Performance Relationship
Posted: 4 Nov 2014
Date Written: November 3, 2014
The relationship between exorbitant chief executive officer (CEO) compensation and weak performance has been widely criticised as an abuse of managerial power and the intrusion of agency problems. This study examines whether the agency problem of free cash flow (FCF), identified by Jensen (1986), influences the CEO pay-performance relationship at firms. The FCF hypothesis suggests that firms with low growth opportunities and excess funds reduce managers’ incentives to improve firm value by providing them the opportunity to indulge in value-destroying activities that enhance their personal benefits. Using a sample of public listed firms in the United States, covering fiscal years 2004 to 2011 (inclusive of both years), we provide new evidence suggesting that the CEO pay-performance relationship is weaker for low growth firms with high FCF. Moreover, as expected, this relationship is significantly positive for high growth firms.
Keywords: free cash flow; growth opportunities; CEO compensation; firm performance.
JEL Classification: G32, J33, L2, M12, M4
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