Academic journal article Quarterly Journal of Business and Economics

The Role of Performance-Based Compensation in Reducing the Underinvestment Problem

Academic journal article Quarterly Journal of Business and Economics

The Role of Performance-Based Compensation in Reducing the Underinvestment Problem

Article excerpt

INTRODUCTION

Firms' growth opportunities and cash flow environments affect their investment decisions. Jensen (1986) provides the well-known free cash flow problem as a classic example: managers of low growth, high cash flow firms prefer to invest the free cash flow in unprofitable ways that directly or indirectly may benefit themselves, rather than payout the cash flows to shareholders. He suggests that when conditions of free cash flow are present, the use of incentive pay becomes more important as an internal control mechanism. Pay for performance reduces the need for monitoring by more closely aligning the interests of managers and shareholders.

High growth firms, like high cash flow firms, may suffer from monitoring problems because less of their value comes from easier-to-monitor assets in place. Smith and Walls (1992) suggest that pay for performance is more important in these firms. As in low growth firms suffering from the free cash flow problem, cash flows affect the severity of agency and monitoring problems in high growth firms. This study examines the underinvestment problem in high growth firms and determines under what conditions of growth and cash flow increasing pay-performance sensitivity is associated with improved firm performance.

Firms with abundant growth opportunities will suffer from an underinvestment problem to the extent that their managers do not choose to invest in the positive net present value (NPV) growth opportunities available. Possible reasons for underinvesting in growth opportunities are managerial risk aversion, lack of effort, perquisite consumption, or insufficient internally generated cash flows coupled with an aversion to raising external capital. Growth firms with low levels of internally generated funds may be especially susceptible to the underinvestment problem due to a growth-resource mismatch. Abundant growth opportunities may exacerbate stockholder-manager conflicts due to the wider latitude managers in investment decisions. These decisions are especially difficult for shareholders to monitor and increase the need for internal control systems. Pay for performance is an important feature of firms' internal control systems and may reduce the agency conflicts associated with underinvestment in growth firms.

This study tests the growth incentive hypothesis which states that without proper incentives, managers of firms with abundant growth opportunities and low cash flow will underinvest. We explore growth firms' cash flow environments and identify conditions where increasing pay-performance sensitivity is associated with higher firm performance. We find that firms with abundant growth opportunities benefit from increased long-term pay-performance sensitivity. Correcting for the self-selection bias that arises when firms choose their level of cash flow, we observe that the need for pay-for-performance incentives becomes less significant for growth firms. These firms, however, would benefit if their free cash flows were lower which is consistent with Jensen (1986). Our results suggest that the need for strengthening performance-based compensation becomes less significant in growth firms when they are able to reduce their free cash flow by increasing interest or dividend payouts.

GROWTH OPPORTUNITIES, FREE CASH FLOW, AND INCENTIVES

Smith and Watts (1992) analyze how the presence of growth opportunities affects CEO incentive compensation.(1) The principal-agent literature predicts that, in investment decisions in large firms where the managers are better informed than the shareholders, the managers (agents) will not necessarily choose to invest in all the available positive NPV projects because shareholders (principals) are assumed to be diversified and, therefore, risk-neutral with respect to any firm. Managers, on the other hand, cannot diversify firm-specific risk (and, therefore, the risk of their compensation) and are risk-averse. Without proper incentives, managers will not invest in projects they deem too risky or whose payoffs are too distant, even if the projects have positive NPVs. …

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