Transmission Mechanisms of Executive Compensation to Cost of Equity Capital

Abstract

Purpose: The nature of each component of executive compensation varies, resulting in variances in executive incentives and investor pricing. To examine whether there is a differential relation between executive compensation components and cost of equity capital, this study decomposes the effects of executive compensation components on the cost of equity capital into wealth alignment, contribution, time horizon, and equity incentive effects. Design/methodology/approach: The hypotheses on the impact of each transmission mechanism of executive compensation component are separately developed in this study. The regression analyses are based on a sample of 11,649 firm-year observations of the U.S. listed companies during 1998-2014. Findings: The findings support all hypotheses by showing a significant reduction in cost of equity capital for bonus plans, long-term performance plans, and shareholdings, but a significant increase in cost of equity capital for salary and stock option. Research limitations/implications: The conclusions of this study are based on an examination of publicly listed companies in the United States; the hypotheses can be tested in other countries with various business environments and cultures. Originality/value: This study is a first attempt to explain the transmission mechanisms of executive compensation components and cost of equity capital by presenting evidence in support of wealth alignment effect, contribution effect, time horizon effect, and equity incentive effect.