Executive Pay Disparity and the Cost of Equity Capital

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2013-09-15

Summary:

Editor's Note: 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.

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Link:

http://blogs.law.harvard.edu/corpgov/2013/09/15/executive-pay-disparity-and-the-cost-of-equity-capital/

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Blogs.law Aggregation Hub » The Harvard Law School Forum on Corporate Governance and Financial Regulation

Tags:

academic research empirical research executive turnover equity capital executive compensation cost of capital management succession entrenchment k.c. john wei yuan huang zhihong chen

Authors:

R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

09/15/2013, 15:00

Date published:

09/15/2013, 09:50