The effect of capital market pressures on the association between R&;D spending and CEO option compensation

We examine the effect of capital market pressures for meeting earnings benchmarks on the relationship between R&D spending and CEO option compensation. We consider a particular scenario when firms face small earnings declines but could opportunistically reduce R&D spending to increase reported earnings. We find that firms with income reporting concerns punish their CEOs with lower option compensation when R&D spending increases but reported earnings decreases. Further, for firms with income reporting concerns, we find that the penalty for increasing R&D is greater when the firms frequently miss quarterly earnings benchmarks in the year. Overall, our findings suggest that the adverse consequence on CEO options encourages short-run compensation-motivated actions to eliminate or postpone R&D projects with positive net present values.     

R&D productivity following first-time CIO appointments

Prior studies find that firms announcing the appointment of a new chief information officer (CIO) are rewarded by stock price increases, suggesting that the market expects new CIOs to add longterm value to the firm. In this paper, we examine whether first-time CIO appointments result in improved R&D productivity. We focus on R&D investments because one role of IT management is to aid in discovery and management of growth opportunities. Successful R&D activities are designed to create the type of knowledge-based, growth-critical assets (new or improved products, better distribution methods, etc.) that effective IT management would be expected to assist. After controlling for industry performance, we find that the productivity of R&D improves significantly after the appointment of a new CIO for appointments before 1999 (1997–1998) but not for appointments in later years (1999–2007), and that productivity improvements over the entire sample period occur for CIO appointments by firms with superior IT capabilities. Our results for R&D investments suggest that new CIOs improve the way IT is managed and improve their firms' approach to knowledge management.     

Industry expertise on corporate boards

Recent surveys indicate that industry expertise is the most sought-after director qualification. Yet evidence on the value of such expertise is limited. This paper shows that firms that are difficult for non-experts to monitor and advise are more likely to appoint industry expert directors. Such appointments also depend on the supply of industry-experienced candidates in the local director labor market. Board industry expertise reduces R&D-based real earnings management and increases R&D investments. The increase in R&D spending is value-enhancing: firms with industry expert directors receive more patents for the same level of R&D, their R&D spending is associated with lower volatility of future earnings, and their value is higher. Finally, industry expertise is associated with CEO termination and pay incentives that encourage R&D investments.     

CEO Ownership and Discretionary Investments

Abstract:  This study investigates empirically the relationship between CEO ownership and discretionary investments such as R&D and capital expenditures. We assert that the under-investment problem is high for R&D-intensive projects, while the over-investment problem is high for capital expenditures because of differences in risk between the two types of investments. Building on the linkages between investments and investment-related agency problems, we hypothesize that the relationship between CEO ownership and investments depends on whether increasing ownership mitigates or exacerbates the under- or over-investment problem. We find a non-linear association between CEO stock ownership and R&D investments; R&D investments increase and then decline across increasing levels of ownership. Further, we find that R&D investments and CEO stock options are positively associated at high levels of option holdings. In contrast, capital expenditures do not vary with CEO ownership (stock or options). Finally, consistent with our underlying assumption, we find that the influence of R&D investments on future firm risk is significantly larger than that of capital expenditures. Our findings indicate that managerial risk aversion affects discretionary investments.     

CEO Overconfidence and Long‐Term Performance Following R&D Increases

We examine the relation between Chief Executive Officer (CEO) overconfidence and significant increases in research and development (R&D) expenditures. Although prior studies reveal a significantly positive market reaction to increases in R&D expenditures in both the long and short run, we find that long‐run stock performance is positive only for firms whose CEOs are not overconfident. Our findings, which may be attributable to overinvestment and the overestimation of future cash flows, imply that R&D resulting from overconfident behavior does not provide any value to firms.     

Managerial incentives and risk-taking

We provide empirical evidence of a strong causal relation between managerial compensation and investment policy, debt policy, and firm risk. Controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on the managerial compensation scheme, we find that higher sensitivity of CEO wealth to stock volatility (vega) implements riskier policy choices, including relatively more investment in R&D, less investment in PPE, more focus, and higher leverage. We also find that riskier policy choices generally lead to compensation structures with higher vega and lower delta. Stock-return volatility has a positive effect on both vega and delta.     

The information content of R&D reductions

An extensive literature shows that R&D intensities and increases are positively related to firm performance, but little research examines the valuation of R&D reductions. This paper fills the void by studying long-term performance following R&D reductions. We find that, contrary to conventional wisdom, large R&D cuts are associated with positive future stock returns. This return drift cannot be explained by asset pricing factors, including R&D intensities and R&D increases. We explore two potential economic motives behind R&D reductions: R&D spillover and firm life cycle. We show that operating performance deteriorates immediately before R&D reductions but exhibits no abnormal pattern afterward. While firm growth falls substantially and variability in profitability reduces, firms with low or declining investment opportunities and mature firms outperform. These findings are inconsistent with the spillover hypothesis, but support the life cycle story that firms attempt to resolve overinvestment in R&D that arises over the course of firm life cycle.     

Investment policy in family controlled firms

We explore the relation between family ownership and corporate investment policy. Our analysis centers on two incentives, risk aversion and extended investment horizons, which potentially influence the level and type of investments that family firms undertake. We find that family firms devote less capital to long-term investments than firms with diffuse ownership structures. When dividing long-term investment into its two components of R&D and capital expenditures, we note that family firms, relative to nonfamily firms, prefer investing in physical assets relative to riskier R&D projects. Additional tests indicate that family firms receive fewer patent citations per dollar of R&D investment relative to nonfamily firms. Overall, all empirical results indicate that family preferences for lower firm risk, across all family sub-types, affects corporate R&D spending and capital expenditures.     

Shareholder governance, bondholder governance, and managerial risk-taking

We examine the relation between the overall corporate governance structure and managerial risk-taking behavior. We find that the overall governance structure has a significant impact on how managers make decisions on investment policy: strong bondholder governance motivates more low-risk investments such as capital expenditure and lower high-risk investments such as R&D expenditures, whereas weak shareholder governance (entrenched managers) leads to more R&D expenditures. Moreover, we find that the effects of governance on investment policy differ significantly between speculative and investment-grade firms. For speculative firms, strong bondholder or shareholder governance leads to more capital expenditures and low R&D investments. For investment-grade firms, strong bondholder or shareholder governance leads to low capital expenditures and an insignificant impact on R&D investments. Furthermore, financing and investment covenants exhibit strong binding power to deter risky investments. Finally, a more dependent (or a less independent) board is associated with low capital expenditures and high R&D investments.     

R&D investments,capital expenditures,and earnings thresholds

Prior studies find that firms cut research and development (R&D) expense in response to earnings considerations. We extend this stream of research by documenting that firms narrowly achieving an earnings threshold also report unusually high capital expenditures. In addition, these firms’ total investments (R&D expense plus capital expenditures) do not vary in response to earnings thresholds, which suggests that, on average, reductions in R&D expense are offset by concurrent increases in capital expenditures. Lastly, our research design allows us to infer that the increased capital expenditures are largely R&D investments that are capitalized instead of non-R&D capital expenditures, suggesting that overall investments in R&D are relatively unchanged.     

Auditor specialization in R&D and clients’ R&D investment-q sensitivity

While research and development (R&D) activities contribute to economic growth via technological innovations, they impose significant uncertainty and agency costs. In this study, we examine the governance role of R&D specialist auditors in affecting clients’ R&D investment decisions. Using a sample of U.S. firms during 2001–2016, we find that R&D specialist auditors’ clients make more efficient investments in the form of a higher R&D investment-q sensitivity. We also find that the reduction in discretionary adjustments of R&D expenses moderates the results. Further, when clients are audited by R&D specialists, their R&D investments are more closely linked to innovative output in subsequent years. Collectively, our results suggest that an auditor’s specialized knowledge induces clients to make better economic decisions.     

CEO and board chair roles: To split or not to split?

We examine the performance and compensation implications of firms' decisions to combine the roles of CEO and board chairman (duality). We document that firms that split the CEO and chairman positions due to investor pressure have significantly lower announcement returns and subsequent performance, and lower contributions of investments to shareholder wealth. Further, these performance outcomes are more negative for firms with higher predicted probabilities of duality based on a model of economic determinants of board leadership structure. We also find that pay-performance sensitivity in CEO compensation contracts are significantly lower following a split in the CEO and chairman positions, and significantly higher following a combination in these positions. Our evidence suggests that on average, board leadership choices by firms and market responses are consistent with efficiency arguments, and recent proposals for all firms to separate the CEO and chairman roles warrant more careful consideration.     

Tournament incentives, firm risk, and corporate policies

This paper tests the proposition that higher tournament incentives will result in greater risk-taking by senior managers in order to increase their chance of promotion to the rank of CEO. Measuring tournament incentives as the pay gap between the CEO and the next layer of senior managers, we find a significantly positive relation between firm risk and tournament incentives. Further, we find that greater tournament incentives lead to higher R&D intensity, firm focus, and leverage, but lower capital expenditures intensity. Our results support the hypothesis that option-like features of intra-organizational CEO promotion tournaments provide incentives to senior executives to increase firm risk by following riskier policies. Finally, the compensation levels and structures of executives of financial institutions have received a great deal of scrutiny after the financial crisis. In a separate examination of financial firms, we again find a significantly positive relation between firm risk and tournament incentives.     

Underperformance of founder-led firms: An examination of compensation contracting theories during the executive stock options backdating scandal

Using the executive stock option (ESO) backdating scandal as a backdrop, this paper examines whether compensation committees can effectively set executive compensation contracts in the presence of a founding CEO. Analyzing a sample of firms accused of backdating ESO grant dates and a control sample of non-backdating firms, we find evidence suggesting that managerial power influences the decision to backdate. Specifically, our analysis indicates the presence of a founder CEO increases the likelihood that ESOs are backdated by 22%. We further find that founder-led firms strongly underperform a matched sample of non-backdating firms. This finding contrasts a number of studies that document superior operating and stock return performance for founder-led firms.     

Narcissism is a bad sign: CEO signature size,investment, and performance

Using the size of CEO signatures in SEC filings to measure individual narcissism, we find that CEO narcissism is associated with several negative firm outcomes. We first validate signature size as a measure of narcissism but not overconfidence using two laboratory studies, and also find that our measure is correlated with employee perceptions of CEO narcissism used in prior research. We then use CEO signatures to study the relation between CEO narcissism and the firm’s investment policies and performance. CEO narcissism is associated with overinvestment, particularly in R&D and M&A expenditures (but not in capital expenditures). Firms led by narcissistic CEOs experience lower financial productivity in the form of profitability and operating cash flows. Despite this negative performance, narcissistic CEOs enjoy higher absolute and relative compensation. Our results are robust to several alternative specifications, including controlling for a popular options-based overconfidence measure used in prior research.     

CEO Compensation and Firm Performance: an Empirical Investigation of UK Panel Data

This paper examines the link between CEO pay and performance employing a unique, hand‐collected panel data set of 390 UK non‐financial firms from the FTSE All Share Index for the period 1999–2005. We include both cash (salary and bonus) and equity‐based (stock options and long‐term incentive plans) components of CEO compensation, and CEO wealth based on share holdings, stock option and stock awards holdings in our analysis. In addition, we control for a comprehensive set of corporate governance variables. The empirical results show that in comparison to the previous findings for US CEOs, pay‐performance elasticity for UK CEOs seems to be lower; pay‐performance elasticity for UK CEOs is 0.075 (0.095) for cash compensation (total direct compensation), indicating that a ten percentage increase in shareholder return corresponds to an increase of 0.75% (0.95%) in cash (total direct) compensation. We also find that both the median share holdings and stock‐based pay‐performance sensitivity are lower for UK CEOs when we compare our findings with the previous findings for US CEOs. Thus, our results suggest that corporate governance reports in the UK, such as the Greenbury Report (1995) that proposed CEO compensation be more closely linked to performance, have not been totally effective. Our findings also indicate that institutional ownership has a positive and significant influence on CEO pay‐performance sensitivity of option grants. Finally, we find that longer CEO tenure is associated with lower pay‐performance sensitivity of option grants suggesting the entrenchment effect of CEO tenure.     

Intangible Assets and Corporate Signaling

Research and development (R&D) and advertising expenditures often result in patents, technologies and brand names which are difficult to accurately value. Under current generally accepted accounting principles (GAAP) these intangible assets are generally not recognized in the financial statements, but instead are expensed in the period that they occur. Prior studies note that the market-to-book ratios of firms with significant levels of R&D and advertising expenditures suggest that investors, at least partially, value these assets. Researchers and practitioners argue that current GAAP, by not recognizing these intangible assets, reduces the usefulness and relevance of accounting reports.We investigate whether companies with significant levels of intangible assets are more likely to emphasize dividend increases and stock repurchases (which are generally perceived as signaling favorable investment opportunities), instead of traditional accounting disclosures, as a means of overcoming adverse selection. Because these assets are difficult to measure, cash distributions may be viewed as a more credible means of signaling firm value to investors. Using analysts' ratings of firms' accounting disclosures, we find that companies with higher levels of R&D and advertising expenditures are less likely to provide extensive accounting disclosures and instead tend to employ dividend and stock repurchase signals. We obtain these results even after controlling for other firm attributes, such as size, stock returns performance, leverage, liquidity and investors' expectations of growth opportunities. We also find that the market reaction to dividend increase and stock repurchase announcements is greater for firms with higher levels of R&D and advertising expenditures, indicating that these announcements are more informative for such firms.     

The impact of costly regulation on R&D investment levels and productivity

Prior research finds that risk-taking has declined after the Sarbanes-Oxley Act of 2002, consistent with the notion that SOX's corporate governance and internal control mandates diverted resources away from corporate risk-taking. We introduce to the accounting literature a new measure of R&D productivity, Research Quotient, to examine whether SOX affects R&D risk-taking and R&D productivity differently and whether the quality of the firm's governance and internal controls, pre-SOX, moderate these relations. While we find the relation between SOX and R&D risk-taking is sensitive to research design choices, we find a consistent positive relation between SOX and Research Quotient. Our evidence indicates that while firms may allocate fewer resources to R&D post-SOX, they concurrently manage their R&D investments more productively. Further, our results are robust to a difference-in-difference design and are stronger for firms with weaker governance pre-SOX.     

Executive risk incentives,product market competition,and R&D

Prior studies have examined the relation between product market competition (PMC) and research and development (R&D) investments, while the impact of executive risk incentives on this relation remains unexplored. In this study, we find that Vega (the sensitivity of executives’ wealth to stock return volatility) weakens the negative relation between PMC and R&D. We also find that Vega strengthens the negative relation between PMC and firm performance when R&D investments grow higher. In sum, our results suggest that high‐Vega compensation portfolios in competitive environments may induce executives to overinvest in R&D projects, therefore hurting firm performance.     

Does CEO reputation matter for capital investments?

This paper examines the association between CEO reputation and corporate capital investments. The efficient contracting hypothesis predicts a positive association between CEO reputation and wealth effects of corporate capital investments. In contrast, the rent extraction hypothesis predicts that the wealth effects of capital investments are negatively associated with CEO reputation. We find that the stock market's responses to announcements of capital investments are more favorable for firms with more reputable CEOs. Moreover, CEO reputation mitigates the negative stock price reaction associated with announcements of capital investments by firms with high free cash flow and low growth opportunities. Additional analysis indicates that firms with more reputable CEOs exhibit significantly better post-investment operating performance improvements than those with less reputable CEOs, especially in firms with high free cash flow and low growth opportunities. Collectively, our results suggest that the efficient contracting hypothesis dominates the rent extraction hypothesis in terms of net economic impact of capital investments on the investing firm.