Aurora Borealis
1 August 2013 CFA Institute Journal Review

Executive Compensation, Share Repurchases and Investment Expenditures: Econometric Evidence from US Firms (Digest Summary)

  1. Thomas M. Arnold, CFA

Results indicate that share repurchases are positively affected by options exercised but not options granted and that share repurchases are negatively related to firm investment/R&D expenditures. This research includes data on the top five executives within a given firm and is thus more longitudinal than previous studies of individual executives with potentially short tenures.

What’s Inside?

The author investigates the interrelationships among compensation components—salary, stock options granted (and exercised), and bonuses—for the top five executives within a given firm from 1996 through 2005 for 667 U.S. firms. In addition, the author analyzes the impact of executive option grants and option exercises on share repurchase activity and the level of firm investment/R&D expenditures. The author groups the top five executives together to avoid such data issues as a single executive having a short tenure and is thus able to capture longitudinal data of sufficient length.

Salary doubles throughout the time period, but total compensation increases fourfold because of the increasing use of stock option grants. Because stock options are intended to align management interests with shareholder interests, the author tests whether options granted or exercised affect stock repurchases or investment in R&D (and other long-term investments).

Stock repurchases are found to be affected by the number of options exercised in the previous period. The author posits that shareholders benefit from options being exercised because the firm is actively preventing share dilution. But long-term investment and investment in R&D are negatively affected by share repurchases and option grants in the previous period. The author concludes that executive stock options up to a certain level may benefit the shareholders but beyond that level, stock options offer no benefit to shareholders.

How Is This Research Useful to Practitioners?

From an investment perspective, practitioners can potentially project the level of stock repurchases by a firm by examining how many executive stock options were exercised in the previous year. The projection may not be perfect but should be consistent with the idea that firms actively avoid stock dilution when executive options are exercised.

From a governance perspective, it is interesting that stock options may be at a level above what is necessary to benefit shareholders. Given the argument that executive stock options align the interests of managers with those of shareholders, increased executive options should benefit shareholders. This research indicates that the benefit to shareholders is limited. Results indicate that salaries are positively and statistically related to bonuses and option grants.

How Did the Author Conduct This Research?

The author uses annual data from Compustat and Execucomp between 1996 and 2005. The combined compensation packages of the top five executives (salary, bonus, and stock options granted) for 667 firms are examined in a longitudinal manner (i.e., for individual firms and for all firms over time). The natural log (ln) of each salary component is regressed back onto itself through time by using dummy variables and a one period–lagged dependent variable (also in log form). When ln(bonus) and ln(stock options granted) are the dependent variables, ln(salary) is also included in the regressions. The regressions also contain such measures as ln(total assets), ln(long-term debt), ln(intangible assets), market-to-book ratio (M/B), (M/B)2, return on assets (ROA), and ROA2. The squared terms test nonlinear relationships that appear to exist. The ln(salary) variable is also found to positively affect the ln(bonus) and ln(stock options granted) variables.

To test the potential beneficial effect of stock options, ln(share repurchases) is used as the dependent variable in a regression similar to the other regressions except that the only compensation variables used as independent variables are ln(option value exercised/realized) lagged one period and ln(stock options granted) lagged one period. The author documents that share repurchases are positively affected by options exercised but not options granted.

The ln(R&D spending) and ln(long-term investment) are regressed in the same manner as ln(stock repurchases), except that ln(stock repurchases) becomes an additional independent variable in each of these regressions. The author finds that share repurchases are negatively related to the level of firm investment/R&D expenditures.

Abstractor’s Viewpoint

It is interesting that stock options may have a limited ability to benefit the shareholder. But I would like to see a more comprehensive examination of this issue. Also, I would be curious to see whether this inference can be made in the current business environment.

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