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Compensation policy and the investment opportunity set.

The problem of motivating managers of large, publicly held corporations to make decisions consistent with shareholder wealth maximization is of considerable interest to both financial managers and financial economists. Although many researchers have examined the ex post relation between executive pay and firm performance,(1) relatively little is known about the ex ante determinants of the structure of executive compensation packages. Recently, Smith and Watts (1992) have argued that cross-sectional differences in compensation agreements are related to variation in firms' investment opportunities. Finns with valuable growth opportunities are expected to have a high degree of information asymmetry between managers and shareholders. To reduce the manager-shareholder agency costs associated with information asymmetry, we would expect growth finns to emphasize incentive compensation over fixed salary. We would also expect growth firms to use longer intervals in assessing performance and to emphasize stock price appreciation over accounting results as the relevant performance measure.

The purpose of this study is to provide empirical evidence on the association between investment opportunities and the compensation practices of public firms.(2) Most prior studies have simply documented the types of compensation agreements used by growth and non-growth samples of firms, with no attempt to assess the degree to which a particular plan is actually used.(3) For example, Smith and Watts (1992) examine industry-level data and find that high-growth firms are more likely than low-growth firms to use stock-based compensation plans. Clinch (1991) and Gaver and Gaver (1993) find similar results using firm-level data.(4) Kole (1994) examines the details of executive compensation agreements and reports that growth firms use relatively long evaluation periods for their executives.(5)

One study that does provide direct evidence concerning the relative emphasis on various forms of executive compensation is Lewellen, Loderer, and Martin (1987). They analyze data for 49 firms for the time period between 1964 and 1973 and find that growth firms emphasize stock-based compensation rather than salary and bonus compensation in the pay packages of their senior executives. Lewellen et al. acknowledge that a shortcoming of their study is the age of the data. However, at the time of their study (published in 1987), SEC disclosure requirements made separate determination of compensation from various sources (such as salary, bonus, stock options, long-term performance plans, etc.) difficult or impossible.

The current study provides up-to-date evidence concerning the relationship between the structure of executive compensation packages and firms' investment opportunity sets by exploiting data that have recently become available as a result of new SEC requirements concerning executive compensation reporting in corporate proxy statements. The sample consists of 321 Fortune 1,000 firms that participated in a compensation survey conducted by the consulting firm of William M. Mercer, Inc. in early 1993. Thus, we have more recent data for a larger cross-section of firms than Lewellen et al. (1987). We also use a finer characterization of the compensation contract and a more sophisticated measure of the investment opportunity set. The results indicate that firms with abundant investment opportunities pay higher levels of total compensation to their executives. In addition to being paid more, executives of growth firms derive a larger proportion of their compensation from long-term incentive agreements, such as performance awards, restricted stock grants, and stock option grants. We find that the executives of non-growth firms in our sample receive less total compensation than growth firm chief executive officers (CEOs) and that they derive a larger portion of their pay from fixed salary.

The remainder of the paper is organized as follows. Section I develops testable propositions concerning the relationship between the investment opportunity set and the structure of executive compensation contracts. Section II describes the sample and outlines the factor analysis that is used to assess the investment opportunities of sample firms. Section III defines the variables used to measure the structure of the compensation contract and presents descriptive statistics for these variables. Section IV reports the results of regressions of compensation policy variables on the composite measure of the investment opportunity set. Finally, Section V summarizes the study and suggests directions for future research.

I. Investment Opportunities and the Structure of Executive Compensation Contracts

This section develops four testable propositions concerning the relationship between the investment opportunity set and the structure of executive compensation contracts.

A. Testable Propositions

A key assumption of this study is that there is relatively high degree of information asymmetry between managers and shareholders in growth firms. Information asymmetry arises because managers have private information about the value of future projects (Bizjak, Brickley, and Coles (1993) and Clinch (1991)) and also because it is more difficult to observe managerial effort in growth firms (Smith and Watts (1992)). As a result, greater potential for managerial opportunism and higher shareholder-manager agency costs exists in growth firms. Executive compensation arrangements in growth firms are therefore expected to differ systematically from those in non-growth firms.

Smith and Watts (1992) argue that, relative to non-growth firms, growth firms will pay higher levels of remuneration to top executives. Higher levels of compensation are expected because the selection of investment projects is assumed to command a higher equilibrium wage than the supervision of existing assets-in-place (Smith and Watts (1982)). Further, Smith and Watts (1992) argue that growth firms are likely to be riskier than their non-growth counterparts. This conjecture is supported empirically by Christie (1995) and Chung and Charoenwong (1991). Managers of growth firms will therefore demand higher total compensation for bearing this risk.

Smith and Watts (1992) also argue that, relative to non-growth firms, growth firms will select compensation packages that emphasize incentive (rather than fixed) compensation. This is because, without the inside information and specialized knowledge of managers, outside shareholders have difficulty ascertaining the menu of investment opportunities available to the firm. In contrast, maintenance and supervision of existing assets are more readily observable.(6) If managerial actions am less observable in growth firms, then these firms' shareholders are more likely to rely on incentive contracts to motivate managers to act in the shareholders' interests.

Lewellen et al. (1987) assert that in firms with extensive investment opportunities, it is important that managers do not make myopic investment decisions. Thus, they predict that executives of growth firms will derive a relatively large proportion of their pay from long-term forms of incentive compensation. Of the variety of long-term performance measures available, Smith and Watts (1992) predict that growth firms will use stock price because it best reflects the effect of managerial actions on investment opportunities. In contrast, accounting results are poor indicators of managers' efforts to enhance a firm's menu of investment alternatives since the accounting system does not value intangible growth options. In this vein, Clinch (1991) observes that potentially long lead times exist between R&D efforts and resulting benefits as they appear in accounting numbers, while stock prices can immediately reflect market perceptions of R&D activities. Lewellen et al. (1987) point out that stock-based compensation also tends to reduce managerial risk aversion by increasing the cost to managers of investments that decrease the firm's share price and raising the pay-off to them from variance-increasing projects.

Testable propositions relating the firm's investment opportunity set to its compensation policy are summarized as follows:

1. Relative to the executives of non-growth firms, executives of growth firms are paid higher levels of total compensation.

2. Relative to the executives of non-growth firms, executives of growth firms derive a smaller proportion of their total remuneration from fixed salary.

3. Relative to the executives of non-growth firms, executives of growth firms derive a larger proportion of their total remuneration from long-term incentive compensation.

4. Relative to the executives of non-growth firms, executives of growth firms derive a larger proportion of their total compensation from stock-based compensation.

B. Control Variables

Gaver and Gaver (1993) argue that, in addition to the investment opportunity set, compensation policy is also associated with both firm performance and firm size. Murphy (1985) documents a significantly positive relation between the level of executive compensation and firm performance. Higher levels of compensation are also expected to be paid to executives in larger firms, because the larger the scope of operations, the greater the demands on top executives. Incentive agreements are expected to be more prevalent in larger firms for two reasons. First, if there are fixed costs and scale economies in administering these plans, they are more likely to be observed in large firms. Second, large firms are more likely to decentralize, making the actions of middle-level managers less observable (Christie, Joye, and Watts (1994)). If incentive agreements adopted for middle-level managers are extended to the top executives of the firm, then a positive relation between size and incentive compensation will be observed.

II. Measuring the Investment Opportunity Set

Tests of cross-sectional variation in the structure of executive compensation agreements require an empirical specification of the investment opportunity set. This presents a problem because the investment opportunity set is unobservable, and no consensus has emerged in the literature concerning an appropriate proxy variable. Myers (1977) argues that investment opportunities account for the excess of total firm value over the value of assets-in-place. Accordingly, the most frequently used measures in prior studies are market-to-book ratios, such as the ratio of the market value of the firm to the book value of assets (Bizjak et al. (1993), Kole (1994), and Smith and Watts (1992)) or the ratio of the market value of equity to the book value of equity (Chung and Charoenwong (1991), Collins and Kothari (1989), and Lewellen et al. (1987)).(7) Other measures of the investment opportunity set include the level of research intensity (Bizjak et al. (1993), Clinch (1991), Kole (1994), MacKie-Mason (1990), and Skinner (1993)) and revenue or return variability (Christie (1995), Chung and Charoenwong (1991), Kester (1986), and Smith and Watts (1992)). Growth firms are expected to have high market-to-book asset and equity ratios, levels of research intensity, and variability measures.

The investment opportunity set is unobservable, and it is likely to be imperfectly measured by any individual proxy. Smith and Watts (1992) recognize this and, while they select the market-to-book assets ratio as their primary measure of investment opportunities, they also conduct sensitivity tests using other variables. Gaver and Gaver (1993) follow a similar approach, using an ensemble of variables to measure the investment opportunity set. We follow the same approach in this paper.

A. The Sample

The initial sample consists of 350 Fortune 1,000 firms that were surveyed by the compensation consulting firm of William H. Mercer, Inc. in early 1993. Twenty of these firms did not provide full-year compensation data for their CEOs and so were dropped from the study. Nine other firms had negative stockholders' equity and were also deleted.(8) The final sample consists of the 321 remaining firms. According to representatives of William Mercer, survey participants were chosen to represent major industrial and service organizations. An analysis of the sample by two-digit SIC codes reveals that, with the exception of agriculture, mining, and real estate and insurance brokerages, virtually all industries are included in the sample. The highest concentrations of sample firms are in the food industry (23 firms, 7.2% of sample), the chemical industry (30 firms, 9.3% of sample), the machinery and computer equipment industry (27 firms, 8.4% of sample), and the banking industry (26 firms, 8.1% of sample).(9) Not surprisingly, sample firms are large and profitable, with a median asset size of $5,668.4 million and a median return on market value (ROMV) of 3.0% in 1992.(10) Thus, the median sample firm is in the ninth decile of the asset distribution and the sixth decile of the ROMV distribution of all COMPUSTAT firms in that year. The median debt-equity ratio of sample firms is 1.06, which is in the sixth decile of all COMPUSTAT firms.(11)

To assess the investment opportunity set of sample firms, we performed a factor analysis like that in Gaver and Gaver (1993). Four measures of the investment opportunity set are used: market-to-book assets (MKTBKASS), market-to-book equity (MKTBKEQ), R&D expense to assets (R&D), and total return variance (VAR).(12) MKTBKASS is the ratio of the book value of liabilities and preferred stock plus the market value of common stock to the book value of total assets. MKTBKEQ is the ratio of the market value of common stock to the book value of common stock. R&D is the ratio of research and development expense to the book value of total assets. VAR is the variance of the total rate of return on the firm, where return includes one-year stock price appreciation, common and preferred dividends, and interest payments. The variance of total return on the firm is based on a time series of at least four annual observations ending in 1992. All other variables are also measured at the end of fiscal 1992. The COMPUSTAT data items used to compute these variables are identified in Appendix A.

Descriptive statistics and correlations among the alternative measures of the investment opportunity set for 1992 are presented in Table 1. The statistics indicate that the median market-to-book ratios for the sample are between one and two (median MKTBKASS is 1.27; median MKTBKEQ is 1.92). R&D as a percentage of total assets averages 2.1%, although the distribution is highly skewed to the right with the median close to zero. Recall that MKTBKEQ, MKTBKASS, R&D, and VAR are all expected to be positively related to growth opportunities. Thus, all variables should be positively correlated with each other. The results support these predictions; all correlations among the variables are significantly positive. However, not all the correlations are high. (The largest correlation, between MKTBKEQ and MKTBKASS, is only 0.84.) An explanation for the low correlations might be that each variable has unique limitations as a measure of the investment opportunity set. To address this problem, a common factor analysis is conducted.

The results are presented in Table 2. In Panel A, the starting communalities (see Harman (1976)) of the individual measures of the investment opportunity set are shown. (Communalities can be thought of as the squared multiple correlation of each measure when regressed on the other three measures.) In Panel B, the eigenvalues of the reduced correlation matrix for the four individual measures of the investment opportunity set are given. According to Cattrell (1966) and Harman (1976), the number of factors needed to approximate the structure of correlations among the individual measures is usually equal to the number of positive eigenvalues that must be cumulated to equal the sum of the communalities. In this case, the first eigenvalue equals the sum of the four communalities, indicating that one common factor parsimoniously explains the intercorrelations among the individual measures. Panel C gives the correlations between the common factor and the four underlying variables. The market-to-book ratios are the most important determinants of the factor score, followed (distantly) by the variance and R&D variables.
Table 1. Descriptive Statistics and Correlations of Four Measures of
the Investment Opportunity Set for 321 Fortune 1,000 Firms at the
End of 1992


This table provides descriptive statistics (Panel A) and
correlations (Panel B) for four measures of sample firms' investment
opportunity sets: 1) MKTBKEQ, the ratio of the book value of
liabilities and preferred stock plus the market value of common
stock to the book value of total assets: 2) MKTBKASS, the ratio of
the market value of common stock to the book value of common stock;
3) R&D, the ratio of research and development expense to the book
value of total assets; and 4) VAR, the variance of the total rate of
return on the firm, where return includes one-year stock price
appreciation, common and preferred dividends, and interest payments.
The sample consists of 321 Fortune 1,000 firms that provided
complete CEO compensation data for fiscal year 1992 for a
compensation survey conducted by William H. Mercer, Inc. and also
had non-negative stockholders' equity.


 Panel A. Descriptive Statistics


 MKTBKEQ MKTBKASS R&D VAR


Maximum 14.073 5.925 0.160 1.386


Third quartile 2.893 1.656 0.028 0.043
Median 1.916 1.275 0.002 0.022
First quartile 1.470 1.087 0 0.009
Minimum 0.200 0.796 0 0
Mean 2.496 1.528 0.021 0.051


 Panel B. Correlations


 MKTBKEQ MKTBKASS R&D VAR


MKTBKEQ 1.000 0.843(***) 0.109(*) 0.147(**)
MKTBKASS 1.000 0.185(***) 0.282(***)


R&D 1.000 0.273(***)
VAR 1.000


* Denotes p-value [less than] 0.05.


** Denotes p-value [less than] 0.01.


*** Denotes p-value [less than] 0.001.


To assess the characteristics of growth versus non-growth firms, we individually regress total assets, return on market value, and the debt-equity ratio on the investment opportunity set factor score. We find that growth firms are significantly smaller and more profitable than their non-growth counterparts. Growth firms also have significantly lower levels of debt in their capital structures. These characteristics conform to our intuitive notion of growth firms as relatively small, risky firms with profitable opportunities. Perhaps the one surprise is that, possibly due to the exploitation of past growth opportunities, the accounting profits of growth firms exceed those of non-growth firms. However, (historical) accounting results [TABULAR DATA FOR TABLE 2 OMITTED] are not necessarily good indicators of managers' efforts to uncover future growth opportunities for the firm.

III. The Data

This section defines the variables used to measure the structure of the executive compensation contracts and provides descriptive statistics for these variables.

A. Variable Definitions

The Mercer survey data consists of information concerning the remuneration of the CEO of each sample firm for fiscal year 1992.(13) For each year, four compensation elements are reported: 1) fixed salary, 2) annual bonus, 3) long-term incentive compensation, and 4) the present value of stock option grants. This level of detail is made possible by recent changes in SEC rules governing the reporting of remuneration. It is not available from proxy statements issued in years prior to 1993.(14)

Section I states four testable propositions that relate the firm's investment opportunity set to its compensation policy. Compensation policy is assessed both as total remuneration (Proposition 1) and also as the proportion of total remuneration derived from fixed salary, long-term incentive compensation, and stock-based incentive compensation (Propositions 2, 3, and 4). Although not directly related to a testable proposition, the proportion of total remuneration attributable to short-term (bonus) compensation is also determined. Definitions of the compensation policy variables are presented below:

Total Compensation = Base salary + Annual Bonus + Long - term Compensation(15)

Long-term Compensation = Gains from the exercise of stock options or stock appreciation rights + the value of restricted stock grants + the value of performance awards or other long-term awards + the present value of current stock option grants(16)

Fixed Salary Ratio = Base Salary/Total Compensation

Short-term Comp. Ratio = Annual Bonus Award/Total Compensation

Long-term Comp. Ratio = Long - term Compensation/Total Compensation

Stock-based Comp. Ratio = Present Value of Stock Option Grants/Total Compensation

For the proportion of total remuneration derived from stock-based compensation (Proposition 4), the present value of current stock option grants is used as the numerator. As described in the Mercer survey, the present value is calculated by 1) assuming 10% annual stock price appreciation over the full term of the option grant and 2) discounting the estimated future gain back to the present at a rate of 14% per annum.(17)

B. Descriptive Statistics

Table 3 presents descriptive statistics for the compensation policy variables. The median level of total compensation for sample CEOs in 1992 is $2,255,700 with an interdecile range of $761,900 to $10,658,600. The median proportion of fixed salary to total compensation is 29.9% with an interdecile range of 9.2% to 70.2%. The median proportion of short-term incentive compensation to total compensation is 14.9% with an interdecile range of 0.0% to 45.9%. The median proportion of long-term incentive compensation to total compensation is 49.3% with an interdecile range of 0.0% to 85.6%. Finally, the median proportion of stock-based compensation to total compensation 22.9% with an interdecile range of 0.0% to 64.2%.

Table 4 presents correlations among the compensation policy variables and the investment opportunity set factor score. For this analysis (and also for the regressions reported in Table 5), a logarithmic transformation is applied to the total compensation variable.(18) Several observations are apparent. The significant correlation between total compensation and the investment opportunity set factor score indicates that growth firms pay higher levels of compensation to their CEOs. This finding is consistent with results reported in Gaver and Gaver (1993) and supports Proposition 1. The significant correlation between total compensation and the long-term compensation ratio (as well as that between total compensation and the stock-based compensation ratio) indicates that firms that emphasize long-term incentive compensation also pay higher levels of total compensation to their chief executives. The opposite is true for firms that emphasize fixed salary, as evidenced by the significantly negative correlation between total compensation and the fixed salary ratio. An explanation is: Growth firms offer higher levels of compensation to compensate executives for the added risk imposed by incentive contracts.

The significantly positive correlation between the long-term compensation ratio and the investment opportunity set factor score and the significantly negative correlation between the factor score and the fixed salary ratio [TABULAR DATA FOR TABLE 3 OMITTED] indicate that growth firms emphasize long-term incentive forms of compensation rather than fixed salary. These results are consistent with Propositions 2 and 3. The correlation between the stock-based compensation ratio and the investment opportunity set factor score is not significant, which is inconsistent with Proposition 4.

Total compensation is the sum of base salary, annual bonus, and long-term compensation. Thus, the fixed salary ratio, the short-term incentive (bonus) ratio, and the long-term incentive ratio sum to one. Also, long-term compensation includes stock-based compensation, so the long-term compensation ratio and the stock-based compensation ratio are significantly positively correlated. Given these relations among the variables, it is not surprising that significantly negative correlations are observed between the fixed salary ratio and the short-term incentive ratio, the long-term incentive ratio, and the stock-based compensation ratio. Significantly negative correlations are also observed between the short-term incentive ratio and both the long-term compensation ratio and the stock-based compensation ratio.

IV. Regression Results

This section reports the results of regressions of the compensation policy variables on the composite measure of the investment opportunity set.

A. Primary Results

First, we regress each compensation variable on the investment opportunity set factor score (lOS SCORE) and appropriate control variables.(19) The control variables are firm size and firm performance. Firm size is measured as the logarithm of total assets (LASSETS). Firm performance is measured as the return on market value (ROMV). It is only included in the total compensation regression. Ordinary least squares is used to estimate the parameters of the regression models, which are listed below.
Model Dependent Variable Independent Variable


1 Log (Total IOS SCORE, LASSETS,
 Compensation) ROMV


2 Fixed Salary Ratio IOS SCORE, LASSETS


3 Short-term Comp. Ratio IOS SCORE, LASSETS


4 Long-term Comp. Ratio IOS SCORE, LASSETS


5 Stock-based Comp. Ratio IOS SCORE, LASSETS


Table 5 presents the results. Column 1 indicates the compensation variable, column 2 shows the number of [TABULAR DATA FOR TABLE 4 OMITTED] observations used in the regression, columns 3 through 6 indicate the intercept and independent variables, and columns 7 and 8 present adjusted R-squared values and F-statistics. Predicted signs, estimated coefficients, and associated t-statistics appear in the body of the table.

In model 1, the coefficient on IOS SCORE is significantly positive. This means that executives of growth firms receive higher levels of compensation than their non-growth counterparts. An explanation is: Managers of growth firms are paid more because the selection of investment projects commands a higher equilibrium wage than the supervision of assets in place (Smith and Watts (1992)). Alternatively, better paid managers expend more effort in enhancing the firm's investment opportunity set by uncovering unexploited profitable growth opportunities. As expected, total compensation is significantly positively related to both the size of the firm and firm performance. The overall model is highly significant, with an adjusted R-squared of 0.23. These results reinforce the findings of Gaver and Gaver (1993) and Smith and Watts (1992), and they support Proposition 1.

In model 2, the coefficient on IOS SCORE is significantly negative. This indicates that, as growth opportunities increase, executives derive a smaller proportion of their pay from fixed salary (and, consequently, a greater share from [TABULAR DATA FOR TABLE 5 OMITTED] incentive compensation). An explanation is: The activities of managers are more difficult for shareholders to monitor in growth firms, and incentive contracts are needed to induce the manager to act in the shareholders' interest. The result is also consistent with incentive contracts successfully motivating managers to expand the firm's investment opportunity set by seeking out new projects. The negative coefficient on LASSETS in model 2 means that the smaller the firm, the greater the emphasis on salary compensation. Similar findings with respect to firm size are reported by Gaver and Gaver (1993). Again, the overall model is highly significant, with results that support Proposition 2.

In model 3, the coefficient on IOS SCORE is insignificant. Thus, while the results of model 2 indicate that growth firms are more likely to emphasize incentive contracts than fixed salary in the pay packages of their executives, the results of model 3 suggest than an annual bonus is not the preferred form of incentive payment.(20) In keeping with this idea, the coefficient on IOS SCORE in model 4 is significantly positive. This means that long-term forms of incentive compensation are the incentive plans of choice for growth firms. Bizjak et al. (1993) argue that growth firms use longer performance intervals to evaluate their executives because growth opportunities often take years to develop, and therefore, it can take a long time for manager-shareholder information asymmetries in growth firms to be resolved. Additionally, Clinch (1991) suggests that long-term compensation contracts are used by growth firms to induce managers with valuable private information to stay with the firm. The positive coefficient on LASSETS in model 4 reflects the general notion that larger firms are more likely to offer incentive forms of compensation to their executives. The overall model is highly significant, with results that support Proposition 3.

In model 5, the coefficient on IOS SCORE, although positive, is not significant. This suggests that, relative to the executives of non-growth firms, executives of growth firms do not derive a significantly higher proportion of their pay from stock-based forms of incentive compensation. This finding is inconsistent with Proposition 4, which predicts that growth firms emphasize stock-based compensation because the stock price rapidly reflects the effect of managerial actions on investment opportunities and also because stock-based compensation induces managers to be less risk-averse in their investment decisions. It is also inconsistent with the results of Clinch (1991) and Gaver and Gaver (1993), who found that growth finns are more likely than non-growth firms to have a stock option plan and contrary to the finding of Lewellen et al. (1987) that growth firms emphasize stock-based compensation in their executive pay packages.

One possible explanation for our anomalous finding is that the dependent variable in model 4 (stock-based compensation) was measured incorrectly. There are three potential sources of error. First, executive option grants are not made in equal amounts each year but, instead, are made in discrete amounts that can vary significantly from one year to the next. Since our study focuses on a single year, we might have mistakenly classified certain firms as minimal or non-options users when they actually made large grants in prior years or planned to make large grants in subsequent years. Second, the price appreciation method used by Mercer to value the option grants provides only an approximation to the true (but unobservable) compensation to the executive.(21) Third, compensation that arises from the exercise of options is included in long-term compensation (and total compensation), but it is excluded from the numerator of the stock-based compensation ratio, which only includes the present value of current grants of stock options.(22) Because of these measurement problems, the results relating to model 5 should be interpreted with caution.

B. Additional Tests

As an additional check on the results, we re-estimate the regressions from Table 5 for two subsamples of the data. First, Smith and Watts (1992) argue that regulation has a confounding influence on corporate policy decisions. Thus, we re-estimate the regressions for the subsample of 246 firms from unregulated industries (those other than utilities, banking, and insurance). The results are qualitatively unchanged from those reported in Table 5. Second, Blackwell and Farrell (1994) argue that compensation contracts are re-negotiated when a new CEO takes office. For our sample, we have 30 firms with complete, full-year compensation for first-year CEOs. Again, the results are very similar to those reported in Table 5. The one notable difference is that firm performance (measured by the return on market value) is not a significant determinant of CEO total first-year compensation (model 1).

We also investigate the possibility that the results are influenced by spurious correlation. Specifically, the market-to-book ratios are the most important determinants of the investment opportunity set factor score (correlations are in excess of 0.9). Firms with a high share price at the end of 1992 will therefore have high assessed investment opportunities. Share price also influences the measurement of total compensation and long-term compensation because both include gains from the exercise of stock options. (Firms with a high share price are likely to have higher exercise gains and, therefore, higher total and long-term compensation.) The fact that share price contemporaneously influences the investment opportunity set factor score and the compensation variables could partially account for the results in Table 5. To address this possibility, we recalculate the factor score using 1991 (rather than 1992) data. We then repeat the regressions reported in Table 5, again using 1992 compensation data. Our results are qualitatively unchanged.

V. Conclusion

This paper furnishes evidence that firms with abundant investment opportunities pay higher levels of total compensation to their executives. In addition to being paid more, executives of growth firms derive a larger proportion of their compensation from long-term incentive compensation, such as performance awards, restricted stock grants, and stock option grants. We conclude that higher manager-shareholder information asymmetry in growth firms leads these firms to emphasize long-term incentive compensation in order to motivate managers to act in their shareholders' interests. Our results are also consistent with long-term incentive contracts motivating managers to take actions to seek out and exploit new investment opportunities. Executives of non-growth firms in our sample receive less total compensation than growth-firm CEOs, and they derive a larger proportion of their pay from fixed salary.

One unexpected finding is that, at least for this sample, CEOs of growth firms do not derive a significantly higher proportion of their pay from stock-based incentive compensation. A similar puzzle is presented by Bizjak et at. (1993) who report that growth firms have compensation packages that are less sensitive to stock returns compared to the pay packages of non-growth firms. In the same vein, DeFusco, Zorn, and Johnson (1991) find that investments in growth opportunities, as measured by R&D intensity, decline significantly following the adoption of an executive stock option plan. Despite this, we view our result with caution because the stock option variable is subject to measurement error. Subsequent research might consider further refining the compensation policy variables, particularly those involving executive stock options. Inclusion of deferred compensation (such as retirement benefits) in the analysis could also fine-tune the results, as could consideration of executives' tax incentives. Additionally, as more years of disaggregated compensation data become available, time-series studies can be conducted to test the four propositions stated in the paper.

Ultimately, all of the firm's policy decisions are interdependent. For example, boards of directors may intentionally change a firm's compensation policies in order to induce managers to adjust the investment opportunity set. This introduces into the problem a fundamental simultaneity that is very difficult to disentangle. The results of the current study provide continuing support for the agency cost explanation of corporate policy choice. However, the inherent simultaneity of multiple corporate policy decisions imparts a degree of complexity to these issues that researchers are just beginning to address.

Appendix A: COMPUSTAT Data Items Used to Compute Four Measures of the Investment Opportunity Set

This appendix identifies the COMPUSTAT definitions of four measures of the investment opportunity set for 321 sample firms at the end of 1992: 1) MKTBKEQ, the ratio of the book value of liabilities and preferred stock plus the market value of common stock to the book value of total assets; 2) MKTBKASS, the ratio of the market value of common stock to the book value of common stock; 3) R&D, the ratio of research and development expense to the book value of total assets; and 4) VAR, the variance of the total rate of return on the firm, where return includes one-year stock price appreciation, common and preferred dividends, and interest payments.

[TABULAR DATA OMITTED]

We are grateful for the helpful comments made by participants at the 1994 Georgia Summer Accounting Research Conference. Special thanks go to Linda Bamber, George Benston, and Dan Dhaliwal. We also thank the consulting firm of William M. Mercer, Inc. for providing compensation data and an anonymous reviewer for many helpful suggestions.

1 Pavlik, Scott, and Tiessen (1993) provide an excellent review of this literature.

2 Smith and Watts (1992) acknowledge that all corporate policy choices are endogenously determined. However, as a starting point for empirical tests of the cross-sectional variation in financing, dividend, and compensation policies, they argue that viewing the firm's investment opportunity set as pre-determined is useful. To develop testable propositions concerning the structure of executive compensation contracts, we also assume that the investment opportunity set is exogenous. However, we recognize that compensation and investment policy actually arise simultaneously: The investment opportunity set influences compensation policy, but the incentives of managers also influence the firm's investment opportunity set. We examine cross-sectional correlations between compensation policy and the investment opportunity set without considering directional causality.

3 Lambert and Larcker (1987) report that growth firms place more weight on stock-based performance measures (and less weight on accounting measures) in determining managerial compensation. Bizjak, Brickley, and Coles (1993) provide indirect evidence that growth firms place a relatively low emphasis on salary and bonus adjustments in their total incentive package for senior managers. However, neither of these studies examines data on the proportions of compensation derived from salary, bonus, stock-based, or long-term accounting-based awards.

4 Similar results are also reported by Balkin and Gomez-Mejia (1985, 1987) and Smith (1988).

5 For example, the mandatory holding period for restricted stock is typically longer for growth than for low-growth firms. Also, the average waiting period to exercise managerial stock options tends to be longer in high-growth firms.

6 Similarly, Bizjak et al. (1993) argue that growth efforts are targeted toward new products, while assets-in-place are used to produce and market existing products. They contend that managers are likely to have superior information about new products, while managers and shareholders have comparable information about products already in the market.

7 Wruck (1993) discusses several limitations of market-to-book ratios as measures of the investment opportunity set, including the importance of certain intangible assets not reported on the balance sheet and appreciation in asset values not reflected in historical cost data.

8 A negative market-to-book equity ratio is not a meaningful indicator of a firm's investment opportunity set.

9 In general, the distribution of industries in the sample is representative of that of the COMPUSTAT firms. For comparison with the sample, 2.0% of the COMPUSTAT firms are in the food industry, 6.5% are in the chemical industry, 7.0% are in the machinery and computer equipment industry, and 3.4% are in the banking industry.

10 Assets are measured at the end of fiscal year 1992. Return on market value is defined as fiscal 1992 income before extraordinary items divided by the market value of the firm at the end of fiscal 1991. (COMPUSTAT data items (18)/(6 - 60 + (199 x 25)).)

11 The debt-equity ratio is total debt divided by the market value of common equity plus the book value of preferred stock. All variables are measured as of the end of fiscal year 1992. (COMPUSTAT data items (6 - 60 - 130)/((199 x 25) + 130)).

12 Gaver and Gaver (1993) also use 1) the consensus choices of growth-oriented mutual funds and 2) the earning-price ratio as additional measures of the investment opportunity set. Mutual fund data are not available for the current study. (The funds variable in the Gaver and Gaver (1993) study was not an important determinant of the investment opportunity set factor score.) The earnings-price ratio is not used because this measure is only valid for firms with non-negative earnings (Chung and Charoenwong (1991)).

13 Data are obtained either directly from proxy statements or from follow-up telephone calls. If no executive is designated as the CEO in the proxy statement, the most highly paid of the president or chairman of the board is selected for use in the analysis. The results of the survey are reported in the April 21, 1993 issue of The Wall Street Journal.

14 The majority (approximately 80%) of the sample are calendar-year firms. Most calendar-year firms issue proxy statements in March or April, which report remuneration for the previous calendar year. Thus, 1993 proxy statements contain compensation data for fiscal year 1992. Compensation data for sample firms that had not yet released a proxy statement at the time of the survey are obtained directly from the firms through telephone interviews.

15 Compensation required by the SEC to be disclosed as "Other Annual Compensation" (such as perquisites, tax reimbursements, or dividend equivalents) or as "All Other Compensation" (such as company contributions to defined-contribution plans or premium payments for split-dollar life insurance) is also included in the total compensation figure.

16 Long-term compensation is a hybrid variable, consisting of 1) current grants of stock options and restricted stock and 2) current payouts based on past grants of performance units and the current exercise of stock options granted previously. Mercer cautions that over time, stock options appear twice: once as an estimated present value at grant and then again when the CEO exercises the options. This is not a major concern in our study because the analysis is cross-sectional, rather than cross-time.

17 This represents an expected market rate of return that is comprised of the 1992 average yield on a ten-year Treasury bond (7%) plus an equity risk premium (7%). Mercer points out that, because the SEC gives companies a choice in how to report stock option values, it is necessary to develop a uniform methodology that permits meaningful comparison across companies. (Companies can either report option values on a grant date present value basis using a valuation method such as Black-Scholes or on a potential realizable value basis, assuming annual stock price appreciation of 5% to 10% over the life of the option.) Mercer uses a 10% growth rate, combined with a discount rate based on the capital asset pricing model to calculate the estimated present value of the future gain for all current stock option grants. Factors taken into account in the discount rate calculation include the market price at grant, the option exercise price, the option term, the risk-free rate, and the equity risk premium. Dividend yield is ignored, and the average company beta is assumed to be one. When companies do not disclose market price at grant, or option term, typical plan provisions are used.

18 Gaver and Gaver (1993) and Smith and Watts (1992) also use a logarithmic transformation to reduce the high degree of skewness in the total compensation variable.

19 Results of regressing the short-term compensation ratio on the investment opportunity set factor score, while not directly related to a testable proposition, are also presented for completeness.

20 For our sample, executives of both growth firms and non-growth rinns derive comparable proportions of their pay from annual bonus payments. Of course, since executives of growth firms are paid greater total amounts of compensation, they also receive higher dollar magnitudes of bonus payments.

21 For example, Mercer ignores dividend yield in valuing the options. Since growth firms tend to have low dividend yields relative to non-growth firms (Gaver and Gaver (1993) and Smith and Watts (1992)), by ignoring yield differentials, Mercer understates the value of growth firm options. We thank an anonymous reviewer for suggesting this possibility to us.

22 Since compensation from the exercise of stock options is not reported separately in the Mercer data, we cannot separate it from other forms of long-term compensation.

References

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Balkin, D. and L. Gomez-Mejia, 1987, "Toward a Contingency Theory of Compensation Strategy," Strategic Management Journal (March/April), 169-182.

Bizjak, J.M., J.A. Brickley, and J.L. Coles, 1993, "Stock-Based Incentive Compensation and Investment Behavior," Journal of Accounting and Economics (January/April/July), 349-372.

Blackwell, D.W. and K.A. Farrell, 1994, "Changes in the Structure of CEO Compensation and the Firm's Pay-Performance Sensitivity Following CEO Turnover," University of Houston Unpublished Manuscript.

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Chung, K. and C. Charoenwong, 1991, "Investment Options, Assets in Place, and the Risk of Stocks," Financial Management (Autumn), 21-33.

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Collins, D.W. and S.P. Kothari, 1989, "An Analysis of Intertemporal and Cross-sectional Determinants of Earnings Response Coefficients," Journal of Accounting and Economics (July), 143-181.

DeFusco, R.A., T.S. Zorn, and R.R. Johnson, 1991, "The Association Between Executive Stock Option Plan Changes and Managerial Decision Making," Financial Management (Spring), 36-43.

Gaver, J.J. and K.M. Gaver, 1993, "Additional Evidence on the Association between the Investment Opportunity Set and Corporate Financing, Dividend and Compensation Policies," Journal of Accounting and Economics (January/April/July), 125-160.

Harman, H.H., 1976, Modern Factor Analysis, 3rd ed., Chicago, IL, University of Chicago Press.

Kester, W.C., 1986, "An Options Approach to Corporate Finance," in E.I. Altman, ed., Handbook of Corporate Finance, New York, NY, John Wiley and Sons.

Kole, S., 1994, "The Bundling of Compensation Plans," University of Rochester Unpublished Manuscript.

Lambert, R.A. and D.F. Larcker, 1987, "An Analysis of the Use of Accounting and Market Measures of Performance in Executive Compensation Contracts," Journal of Accounting Research (Supplement), 85-125.

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MacKie-Mason, J.K., 1990, "Do Taxes Affect Corporate Financing Decisions?," Journal of Finance (December), 1471-1493.

Murphy, K.J., 1985, "Corporate Performance and Managerial Remuneration: An Empirical Analysis," Journal of Accounting and Economics (April), 11-42.

Myers, S., 1977, "Determinants of Corporate Borrowing," Journal of Financial Economics (November), 147-175.

Pavlik, E.L., T.W. Scott, and P. Tiessen, 1993, "Executive Compensation: Issues and Research," Journal of Accounting Literature (Vol. 12), 131-189.

Skinner, D.J., 1993, "The Investment Opportunity Set and Accounting Procedure Choice: Preliminary Evidence," Journal of Accounting and Economics (October), 407-445.

Smith, C.W. and R.L. Watts, 1982, "Incentive and Tax Effects of U.S. Executive Compensation Plans," Australian Journal of Management (December), 139-157.

Smith, C.W. and R.L. Watts, 1992, "The Investment Opportunity Set and Corporate Financing, Dividend and Compensation Policies," Journal of Financial Economics (December), 263-292.

Smith, S., 1988, "On the Incidence of Profit and Equity Sharing: Theory and an Application to the High Tech Sector," Journal of Economic Behavior and Organization (January), 45-58.

Wruck, K.H., 1993, "Stock-Based Incentives and Investment Decisions: A Comment," Journal of Accounting and Economics (January/April/July), 373-380.

Jennifer J. Gaver and Kenneth M. Gaver are Assistant Professors of Accounting at The University of Georgia.
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Title Annotation:includes appendix
Author:Gaver, Jennifer J.; Gaver, Kenneth M.
Publication:Financial Management
Date:Mar 22, 1995
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