Executive pay disparity – as when the CEO earns significantly more than the other top managers – has become a red flag issue for investors. Moody’s, for instance, sees high disparity as a credit risk. It can also affect the cost of equity capital, as a study by Zhihong Chen, Yuan Huang and K.C. John Wei has shown.
The cost of capital is one of the key considerations for managers in their capital budgeting and corporate financing decisions because a higher cost can mean fewer projects leading to firm growth. It can also reflect investor sentiment in terms of their risk-return trade-off when allocating resources. So anything that could increase that cost is a cause of concern.
The authors consider two perspectives on executive pay disparity – one in which it could increase the cost of capital and one in which it would have no effect or decrease it – and apply that to a large set of data.
The first perspective pertains to managerial power and holds that pay reflects the bargaining power of executives. If the CEO earns considerably more than other executives, then this is a sign they are entrenched and there could be greater difficulties finding a successor CEO. Such a situation is expected to increase the cost of capital because of the risk of severe agency problems with an entrenched CEO and the higher succession risk.
The other perspective sees a large pay gap as the prize in a tournament between senior executives and the high CEO package as an incentive for subordinate managers to stay with the firm and invest in developing firm-specific skills. This is expected to have the opposite effect on the cost of capital because it will reduce CEO entrenchment, increase the bargaining power of the board, and reduce CEO succession risk.
To find out which situation was at play, the authors looked at 13,454 firm-year observations from 1993 to 2007. They used stock prices and analyst earnings forecasts to compute the implied cost of equity. They correlated this with the ratio of total CEO pay to the sum total pay of the top five executives in firms (the “CEO pay slice”) and controlled for other variables including those related to corporate governance. The data was put through several robustness tests and alternative hypotheses. But the results all pointed to one conclusion: investors view high executive pay disparity as a symptom of managerial power. There are economic consequences for this.
“An increase in the CEO pay slice from the 10th percentile to the 90th percentile increases the cost of equity by 13.9 basis points. Under reasonable assumptions, this means that 43 per cent of the valuation effect due to CEO pay slice that has been reported in other research is attributable to the difference in the cost of equity capital,” the authors said.
They then looked in detail at what was driving this association and found two situations that increased the risk due to a high CEO pay slice. One was in firms with more severe agency problems of free cash flow, meaning they had high operating cash flow but low investment opportunities. The other was in firms where CEO succession planning is more important because the firm operates in a less homogenous industry, making it more difficult to find a replacement, and there is a high likelihood of the CEO leaving.
Firms with larger CEO pay slice also experienced significantly higher stock return volatility around the time of CEO turnover, further supporting the idea that large executive pay disparity indicates a high succession risk.
“We show that investors do incorporate this information into their resource allocation decisions,” the authors said.