EXECUTIVE COMPENSATION AND FIRM FINANCIAL PERFORMANCE: A CRITICAL LITERATURE REVIEW

Citation:
OCHIENG’ ELLYDUNCAN. EXECUTIVE COMPENSATION AND FIRM FINANCIAL PERFORMANCE: A CRITICAL LITERATURE REVIEW. Nairobi: University of Nairobi; 2013.

Thesis Type:

PhD Thesis

Abstract:

There has been growing academic interest in the compensation of senior management in corporate enterprises. This interest stems from a concern about the motivation of management as well as concerns about equity and fairness coupled with the importance of corporate governance in enterprises. Shareholders as principals in entities desire maximization of stock returns for a given level of risk and they naturally wish that their firms design compensation systems that motivate senior executives as their agents to pursue policies that meet the principal objective of shareholder wealth maximization.

This desk review of relevant theoretical and empirical literature investigates whether the executive compensation – performance link meets an optimality test ex –ante or ex – post under the agency based models as well as other alternative paradigms that explain managerial actions. From the review findings, a confusing debate rages among academics about the relationship between executive compensation and firm financial performance. This confusion manifests itself in a number of ways: in the range of empirical specifications for pay to performance regressions in the literature; in the wide discrepancy in estimates of pay performance sensitivities and in controversy over the appropriate level of executive holdings of stock and stock options.

Differences in research methodology explain some of the inconsistent conclusions notwithstanding that there is even a lack of consensus among some studies that use identical or very similar research designs. Foremost, the measurement of firm success is in intself controversial regarding adoption of performance measures. Also controversial is treatment of the components of compensation. The diverse set of disciplines involved in the study area and the wide variety of methods used to investigate the main questions complicates the way to consensus especially on incorporation of organizational contextual settings and other contingency factors for executive compensation.

Research gaps emerging in the literature review include; wide variations of pay performance sensitivities derived within agency models, minimal evaluation of explanatory values of alternative paradigms to the agency models, undefined relationships between pay performance sensitivity and the performance metric applied, undefined relationship between executive compensation components and past and future organizational performance levels, inexplained sensitivity of the pay performance link to organizational contextual effects of ownership and internationalization, unspecified possibility of dual causality between executive compensation and firm performance and the information content of executive compensation plan adopted by a public enterprise.

The study recommends future research effort for bridging the knowledge gaps using alternative paradigms while adressing the methodological issues of empirical specifications, causality, fixed-effects, first-differencing, and instrumental variables. On the empirical specifications, the studies need to reconsider the causality relationships, operationalization of research variables, use of panel data and incorporation of control variables like demographic characteristics, corporate governance mechanisms, regulation, firm ownership and globalization.

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