Wealth Creation and Managerial Pay, MVA and EVA as Determinants of Executive Compensation

Wealth creation and managerial pay: MVA and EVA as determinants of executive compensation Ali Fatemi a , Anand S. Desai b , Jeffrey P. Katz b, * a DePaul University, Chicago, IL, USA b Kansas State University, Manhattan, KS, USA Received 1 June 2001; received in revised form 1 October 2002; accepted 1 October 2002 Abstract Designing effective compensation contracts has become increasingly complex due to the globalization of th
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  Wealth creation and managerial pay: MVA and EVAas determinants of executive compensation Ali Fatemi a  , Anand S. Desai  b , Jeffrey P. Katz  b, * a   DePaul University, Chicago, IL, USA  b  Kansas State University, Manhattan, KS, USA Received 1 June 2001; received in revised form 1 October 2002; accepted 1 October 2002 Abstract Designing effective compensation contracts has become increasingly complex due to theglobalization of the executive work force and the multitude of incentive schemes. We examine therelationships between managerial pay and firm performance among domestic and global firms usingeconomic value added (EVA) and market value added (MVA) to assess wealth creation. Our work suggests that top managers in domestic- and globally focused firms are not only incented to increaseEVA, but also rewarded for past additions to MVA. The results of our research suggest that managersof highly globalized firms tend to be paid at higher levels, reflecting the increased complexity of managing global firms. D  2003 Elsevier Science Inc. All rights reserved.  JEL classification:  J33; G3  Keywords:  Compensation; Pay for performance; Economic value added; Market value added 1. Introduction Previous studies have proposed that optimal executive compensation contracts perfectlyalign the interests of the executives with those of the firm’s shareholders (Grossman &Hart, 1983; Harris & Raviv, 1979). In theory, such contracts act as incentive mechanismsfor executives to engage in behaviors that maximize the firm’s value and rewardexecutives for such behavior  (Fama, 1980; Jensen & Meckling, 1976). Whether executive compensation contracts meet this test of optimality, ex ante or ex post, is an empiricalquestion subject to ongoing investigation (Tosi, Werner, Katz, & Gomez-Mejia, 2000). 1044-0283/03/$ - see front matter   D  2003 Elsevier Science Inc. All rights reserved.doi:10.1016/S1044-0283(03)00010-3* Corresponding author. Tel.: +1-785-532-7451; fax: +1-785-532-7024.  E-mail address: (J.P. Katz).Global Finance Journal 14 (2003) 159–179  Several studies have examined the relationships between measures of firm performanceand top manager pay. For example, Murphy (1985) found a statistically significant  relationship between the level of pay and performance, while Mehran (1995) found firm performance is positively related to management’s ownership stake and to the percentageof its equity-based compensation. However, Jensen and Murphy (1990) did not find asignificant relationship between changes in firm value and changes in executive compen-sation. Miller (1995) showed no support for a linear relationshi p between pay and  performance, but found strong support for a convex relationship. Hadlock and Lumer (1997) found that pay–performance sensitivities have significantly increased over time for small firms, but not for large firms.More recently, in a study examining the role of boards in setting managerial pay, Porac,Wade, and Pollock (1999) found evidence that boards make comparisons within and between industries in which the firm competes to support their top management compensation decisions. The authors conclude that boards of directors tend to ‘‘anchor their comparability judgments’’ by examining other firms’ performance. This suggests that top manager performance is assessed based on relative measures and with an eye towardthe industry environment affecting the firm.Unfortunately, most of the studies exploring the nature of the relationship betweenmanagerial pay and performance have used accounting-based measures of performance(such as return on equity [ROE] or return on assets [ROA]). Such measures may bear littleresemblance with the economic return earned by the firm since accounting-based measuresdo not account for the risk incurred by the firm’s managers in their search for growth and profitability (Shiely, 1996). For example, earnings growth which may follow a decision to increase the size of the firm does not automatically lead to a per-share growth in firm value because the former may be achieved at excessive capital costs (Copeland, Koller, &Murrin, 1995). In addition, even studies using measures of performance based on market returns fail to adjust returns for the level of risk exposure (Harris & Raviv, 1979). Thus, the exact relationship between pay and performance can be somewhat different than what the empirical results suggest because the impact of risk is not adequately accounted for incommonly employed measures of performance (Lehn & Makhija, 1996; Stewart, 1991).Our study is designed to further clarify the nature of the pay–performance relationship by adding risk to the equation. Specifically, we seek to investigate the relationship betweentop management compensation and two measures of risk-adjusted firm performance:economic value added (EVA) and market value added (MVA). EVA and MVA aremeasures developed and trademarked by the Stern Stewart and Co. First suggested byStewart (1991), EVA can be thought of as a proxy for the measurement of economicreturns. It is the firm’s residual profitability in excess of capital costs. A firm’s EVA is positive when after-tax operating profits exceed the dollar cost of capital (COC). MVA is aclosely related measure in that it is the present value of all expected future EVA and can bethought of as the net present value of the firm.Variations of these measures have been proposed, and used, by others (Copeland et al.,1995; Rappaport, 1986). However, EVA and MVA have received wider attention both inthe corporate world and in scholarly research (see for example, Hodak, 1994; Lehn &Makhija, 1996; Spinner, 1995; Tully, 1993; Uyemura, Kantor, & Pettit, 1996). Includedamong these are studies that have attempted to document the presence (or lack thereof) of   A. Fatemi et al. / Global Finance Journal 14 (2003) 159–179 160  a relationship between EVA and measures of stock price performance. Dodd and Chen(1996), for example, report that EVA explains only slightly more than one fifth (20.2%) of the variation in stock returns for a sample of 566 firms, comparing unfavorably withROA, which explains almost a fourth (24.5%) of the variation. Further, Dodd and Johns(1999) found some differences in performance between the adopters and nonadopters of  EVA. However, as documented by Weaver (2001), there are significant differences in how firms measure EVA. Examining a set of 29 EVA adopters who participated in his survey,he found that none of the respondents measured the EVA the same way. Directly relevant to our purpose is Weaver’s finding that the adopters’ top reasons for implementation of EVA are to ‘‘enhance financial management’’ and to ‘‘enhance compensation metrics.’’Also of direct interest to this work is Kramer and Peters’ (2001) finding that, as a proxyfor MVA, EVA does not suffer from any industry-specific bias. However, they alsoconclude that EVA is consistently outperformed by the ‘‘net operating profit after tax’’measure.We believe EVA and MVA are reasonable proxies for the measurement of owner wealthmaximization while taking into account the relative risk-based costs of doing so (Hodak,1994; Shiely, 1996). However, the relationships between executive compensation andthese measures of firm performance have not yet been explored empirically. In this study,we seek to examine these relationships. Under the pay-for-performance hypothesis, weexpect a positive relationship between executive compensation and firm performance. Inthis study, firm performance is measured in the context of value creation for the owners of the firm using MVA and EVA. We also examine the contribution of these measures inexplaining the cross-sectional variation in executive compensation relative to the account-ing-based measure of ROA.Executive compensation generally consists of several components such as salary, bonus, stock options, and long-term incentive payments. It is plausible that certaincomponents, such as bonuses, are used as a reward for past performance, while other components related to firm value are designed to provide the correct incentive for future performance (Murphy, 1985). The complex design of the total compensation package requires that we separately examine the relationship between firm performance and each of these components.Recently, there has been an increase in the body of research pointing to the globalmanagerial labor market as the basis for better understanding differences in levels of pay,as well as the mix of incentive plan components. That is, there is increasing evidence that top managers in highly global firms have higher proportions of performance-based pay intheir total compensation contract  (Carpenter, Sanders, & Gregersen, 2001). In addition, Richard (2000) suggests that pay policies that include equity participation practices pioneered in the United States are becoming common throughout the global businesscommunity. We hope to assess whether there are differences in the relationships between pay and performance based on the level of international impact of the firm.We also seek to examine the causal order of the relationship—that is, whether compensation serves as a reward for past performance, or as an incentive for enhancedfuture performance. Given shareholder wealth maximization as the goal of the firm, is theexecutive compensation scheme used by the firm incentive-compatible? To answer thisquestion, we use leading and lagged values of firm performance. If compensation is an  A. Fatemi et al. / Global Finance Journal 14 (2003) 159–179  161  incentive for top managers to perform in certain ways, then we would expect top manager  pay to be unrelated to past performance, but instead would observe a positive relationship between current compensation and future performance. On the other hand, if compensa-tion is a reward for superior performance, we would expect top manager pay to be positively related to past performance, but not to future performance (Gomez-Mejia, Tosi,& Hinkin, 1987; Tosi et al., 2000).The rest of our paper is organized as follows. In the next section, we describe our data.We present and discuss our results in Section 3 and our conclusions and implications for further research are presented in the last section. 2. Data Executive compensation and firm performance measures used in this study are obtainedfrom three sources: the Standard and Poor’s ExecuComp database, Stern Stewart and Co.’sPerformance 1000 database, and Standard and Poor’s Compustat database.We define top managers as individuals with the title of Chairman, CEO, President andsenior-level Vice President. Compensation data are obtained from the ExecuComp data- base. In our study, we use three measures of compensation: salary, bonus, and total direct compensation (TDC). TDC is defined as the sum of salary, bonus, value of restricted stock granted, value of stock options granted, and other annual items, which include perquisites, payments to cover executive’s taxes, preferential earnings payable but deferred at executive’s election, and preferential discounts of stock purchases. Data requirementsfor the incentive/reward hypothesis require us to use annual compensation in the 4-year  period from 1992 to 1995.The number of executives varies across the firms in our sample, ranging from 1 to 12.Larger firms tend to have a greater number of executives. Since we are interested in thetotal executive compensation package of the firm, for each firm (and for each year) in thesample period, we aggregate the compensation component for all executives of this firmlisted in the ExecuComp database. Implicit in this aggregation is the assumption that thefirm’s compensation policy applies uniformly to top executives of different ranks. Prior research has shown that this hierarchical assumption is reasonable (Demski & Sappington,1989; Werner & Tosi, 1995).Firm performance measures are obtained from two sources. EVA and MVA areobtained from the Performance 1000 database. ROE and ROA are obtained from theCompustat database.Economic theory, human capital theory, and agency theory suggest that top manager  pay will be positively related to firm size (Agarwal, 1981; Becker, 1964; Deckop, 1988;Jensen & Meckling, 1976). That is, economic theory of marginal revenue products predicts greater pay in firms of greater size (Gomez-Mejia et al., 1987). Additionally, if  an effective CEO can create greater profits for large firms than for small ones, then it islikely that the marginal productivity of the CEO would vary directly with size. Further,human capital theory predicts greater pay in firms of greater size (Becker, 1964). The  prediction follows from the observation that the top position in a larger firm requiresgreater human capital because a larger firm is more complex, more difficult to manage,  A. Fatemi et al. / Global Finance Journal 14 (2003) 159–179 162
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