CEO Remuneration and its Correlation to Firm Performance - Dissertation Example

? JANUARY LONDON SOUTH BANK ACADEMIC YEAR: MODULE Research Methods Module Co-ordinator: Mr Yousuf Khan STUDENT Number: DISSERTATION PROPOSAL: EXECUTIVE REMUNERATION AND ITS CORRELATION TO A FIRM PERFORMANCE Chapter 1: Rationale for research The rationale of the research is based on the need to establish the role of stakeholders, legislation and executives in determining the executive remuneration. The intended research offers to give quality insight in the aspects influencing executive remuneration. The research explains the importance of building strategic consensus when developing executive remunerations. 1.1Introduction Executive compensation, remuneration, or pay is a financial return received by executive persons of organizations. Typically, it is a combination of salary, incentives, and shares of and call options on the stock of a company, ideally configured to consider the government rules and regulations; a company’s goals/strategy and its executive’s desires, tax law and recognitions for the performance. Executive compensation is viewed through the observable outcomes. It should be designed to give appropriate and befitting incentives. Many shareholders do not want or expect executives to take risk with an aim of getting large profit; in fact nowadays there is a significant emphasis on risk control and strengthening of audit committees to ensure that any risks are understood, assessed and managed properly. The financial collapse in 2007 has changed shareholders’ perception in the light of many ‘reckless’ actions taken by executives, particularly in the financial services sector. That is why the compensation of chief executive officers has increasingly been receiving a lot of attention. As basic salaries are not viewed as an adequate method of influencing the performance of the top executives, the other, different types of rewards were brought in. It is feared that top executives, driven by high profits, were/are acting in their own and not a company’s shareholders’ interests thus encouraging the separation of control and ownership in modern companies. That is why Remuneration Committees have now changed inventive plans to ensure that they do not reward short term behaviour or aggressive ‘risk taking’. The executive remuneration or compensation landscape has greatly and rapidly changed during recent years with executive pay remaining a focus point for the UK Government as well as European Commission, shareholders, and media. Draft new rules and regulations will give shareholders new powers to vote down pay arrangements and alter the way organizations will report on the remuneration of directors, which will considerably alter the environment of executive remuneration. Taking into account the changes in the attitude to the remuneration brought about by the last recession and current tightening legislation, the aim of his research paper is to analyse the correlation between Executive Remuneration and a firm performance. 1.2Aims and objectives 1.2.1Aims of the Study To identify and discuss contemporary issues in Executive Remuneration topic; To determine the impact of Executive Remuneration on a firm’s performance To access executive remuneration and its impact on a firm’s evaluation To establish the correlation between Executive Remuneration and firm’s performance. 1.2.2. Objectives of the Study To evaluate the arguments in Executive Remuneration To evaluate the impact of the Executive Remuneration on a firm’s performance using the following proxies: - Return on Assets - Return on Equity -Dividends Yields Share price. To verify the type of correlation between Executive Remuneration and firm’s performance. 1.3. Main research questions The main purpose of this research is to determine the correlation and the impact, if any, of Executive Remuneration on a firm performance; hence this work is aiming to answer the following questions: What are the determinants of Executive Remuneration? 1.3.1 Objective 1- the determinants for executive remuneration are multifaceted and must involve all the stakeholders. The determinants access the impact of executive remuneration on corporate strategy and profitability. The aim is to look into the relationship between government policy, stakeholders and executive reward system. What is the impact of Executive Remuneration on a firm’s Return on Assets and Return on Equity? 1.3.2 Objective 2- executive remuneration can have either positive or negative impacts in the overall running of an organization and the return on equity (RoE) or return on assets (RoA). This question intends to look into the details affecting organizational economic benchmarks in comparison to executive remuneration. What is the impact, if any, of Executive Remuneration on a firm value? 1.3.3 Objective 3- executive remuneration can be a threat to the corporate overall strategy. The objective of this research question is to ensure that the organizational interests are protected. The question is meant to answer the vacuum that exists between executive remuneration and firm’s wellbeing and worth or value. How has Executive Remuneration evolved in the last decade and what are the future tendencies? 1.3.4 Objective 4- for this research to be effective, the evolution of executive remuneration must be assessed. The objective is to predict the impact of the current executive remuneration policies in the future. Hypothesis There needs to be policy framework that addresses the interrelationship between executive remuneration and stakeholders expectations. The performance of a firm is said to be negatively related to exaggerate executive remuneration procedures. The evolution of executive remuneration policies is likely to affect the future expectations of stakeholders with regard to the relationship between remuneration and organizational goals. Empirical model ER=GP+ (RoA+ RoE) +S+CGQ ER executive remuneration RoA return on assets RoE return on equity S all the stakeholders CGQ Quality of corporate governance Theoretical framework The intended research is supported and facilitated by the agency theory. The theory suggests that organizational matters must be inclusive and strategic. Successful decisions must take into consideration the expectations and interests of the stakeholders while fulfilling the needs of executives. The theory suggests that there is need to a consultative framework to ensure that decisions are structured. During the research, the theory shall play an active role in ensuring that the suggested government policy is weighed with expectations of the stakeholders and organizational productivity. Philosophical framework The epistemology of the research points to the need to have adequate controls on how executive remuneration is awarded. The process calls from transparency and consultations with all stakeholders. The research must address the role of executive committee, buyers, consumers, shareholders and government policy in the organizational effectiveness. There is a need to let the executive have a freehand in organizational running. However, this must be closely monitored through vibrant and competent institutions and structures. Chapter 2: LITERATURE REVIEW 2.1 Introduction Literature review intends to assess the significant points of current knowledge comprising substantial findings, hypothetical and methodological contributions to a specific topic. Literature review is a secondary source and provides information of preceding research and experimental work. 2.2 Aim of Literature Review The aim of a literature review is to Develop a theoretical structure of the topic; Describe major definitions and terminologies; Find models, researches, studies, case studies that support the subject area. 2.3. Literature review In recent years, the subject of executive remuneration has led to many controversies. This is indeed a topic that has fuelled extensive academic literature and continues to attract interest of many researchers. Executive compensation is a composite scale whose interpretation is complex because it binds an incentive system, elements of social status and plays an important role in personal relationships, professional internal and external mobility leader. This complexity is also reflected in the schedule, the amount of compensation elements and their nature as some are paid to term (or long term such as pensions), there is some degree of randomness (variable, value-added removed the exercise of stock options) and can finally take various forms. Indeed, much of the literature has focused on the impact of executive compensation on risk taking. Principal agent theory (Jager, 2008) is one of the first theories to address this issue, illustrating remuneration policies that shareholders must be put in place to encourage managers to take more risk, knowing that they are nature, risk-averse as stipulated in the agency theory (Jager, 2008). In the past almost every research study that examined executive remuneration principally concentrated on one constitute of executive remuneration, namely stock incentives, at the cost of other. In this analysis, as mentioned above, this study would take a detailed, thorough and recent perspective of issues pertained to executive remuneration. The utilization of stock alternatives has been a predominant and wide spread form of executive remuneration. Many studies therefore have strongly concentrated on this remuneration’s form. For firms, there are numerous reasons to make stock awards to senior executives. According to Espenlaub (2004), stock award are provided to executives of new economy to bring into line the interests of shareholders with the major objectives of executives, minimize the costs of agency, accomplish valuable tax benefits for the organization as well as for the employees, and appeal and keep executives with noteworthy awareness of new and innovative technologies. According to Larker & Ittner (2003), modern companies provide stock alternatives to executive persons for the reason that the organizations have complexity producing enough “cash flow” to give high level of wages to executive level of persons. According to the thought of Murphy (2003), an outsized group of larger firms vie in the competitive market for executives of high quality. The contracts of compensation that they grant to this type of executive people the other organizations to employ the similar compensation structure: addition of stock alternatives as a significant part of remuneration package. There is one more reason evoked is associated to what the author calls the “perceived cost view”. But differently, the incorrect perception is that executive levels of persons remunerated with stock alternatives develop inexpensive form of remuneration. Previous studies show that until 2000, executives were mostly remunerated with stock alternatives. However, in some cases of fraudulent bankruptcy like “Enron and WorldCom”, are indirectly associated to the considerable number of stock alternatives granted to the executive persons. The new rules and regulations of the market comprise provisions that have a major influence on the compensation and incentives of executives of public organizations. Contracts are drafted in such a way that the incentives for the performance of top executive are a function of the remuneration of the firm (Fleming & Stellios 2002). Research indicates that there are many and complex determinants of the executive compensation. Most of these determinants revolve around economic factors (Core & Larcker 1999). Executive performance must asset the benchmarks that positively address return of equity (ROE) and return of assets (ROA). A firm performance has many complexities that stem from market demands and operations. The research on these complexities has not been exhaustive. The ability of a top executive to steer a company in a dynamic market environments receives a lot of attention. The executive remuneration is determined by market risks, firm size and ownership (Hallock 1998). These factors are intertwined with both internal and external organizational and marketplace dynamics (Jones & Kato I996). Therefore, determinants of executive compensation have different measures. This necessitates further research into the determinants of executive compensation and value of the concerned firms. These incentives gave birth to the relationship between top executive remuneration and performance of the firm. The compensation scheme should insulate the top executives from potential adverse outcomes. Corporate governance plays a vital role in the development of western economies. Therefore, performance-linked remuneration for top management represents the bulk of the remuneration payable to top corporate leaders (Cosh & Hughes 1997). Past financial performance has an impact to the chief executive compensation. The same case applies to contemporaneous performance. Not many researches capture the impact of the relationship between executive performances and pay (Bebchuk & Jesse 2003). Previous studies show executive compensation for good or unsatisfactory result is symmetrical. In most cases, the difference in appreciation is negligible. Accounting and market returns are influenced by factors beyond the influence of the top executives. There are proposals that, for successful evaluation of performance by the top executives, the advisory board must be contracted (Kubo 2002). This is because they provide quality managerial input that influences the performance of the executive. Previous researches suggest that there is a link between executive performance and compensation (Fleming &Stellios 2002). Cash compensation and firm performance have s positive relationship in the running of corporate. Using the shareholder wealth as the yard stick, research suggests elasticity of 0.1 in the pay-performance relationship. This indicates that, when the shareholder wealth rises by 10 percent, cash compensation increases by 1 per cent. According to Murphy, this applies to all industries. Studies show that, using both accounting based and market-based measurements, there is a robust connection between executive compensation and performance. The past performance has a significant impact the current executive compensation. According to Cosh and Hughes (1997), the total compensation is influenced past performance. Hallock argues that past performance cannot be separated from cash and total compensation (Bebchuk & Jesse 2003). Market-based and accounting based indicators of performance agree with this theory. The effect of returns on compensation, in accounting measurement, decays proportionally with time. The pay of the top executive is related to the current shareholders return (Chalmers & Stapledon 2006). This relationship is both significant and positive. The executive compensation is negatively related to the market and industry returns. Studies also suggest that market return has a profound impact on cash compensation compared to industry return. The size of the firm is a strong determinant of executive compensation (Core & Larcker 1999). Research on most industries indicates that the size of the firm and revenues relate strongly with executive cash compensation. However, most of the previous research falls short of giving a formula for maximizing the executive performance beyond the use of cash compensation (Chalmers & Stapledon 2006). This has demanded a re look into the designing of performance contracts for the top executives. The top executive’s compensation is influenced by growth opportunities, tenure, firm risks and the age (Fleming &Stellios 2002). Risks have a remarkable impact on total compensation and not cash compensation. Research shows that investment opportunities play a significant role in both cash and total compensation of the top executives. Research shows that there is a relationship between compensation and performance (Fleming & Stellios 2002). Some studies show that that separation of control and ownership in firms, in the oil sector, is responsible for agency problems. The top executive becomes the agent of decision making process on behalf of the shareholders (Chalmers & Stapledon 2006). Traditionally, running of firms did not demand specialization. However, developments in the United Kingdom and United States are responsible for the review of firm’s management. Currently, the top executives have the power to monitor and supervision organizational actions on behalf of the shareholders. This comes with a responsibility of ensuring the interest of both the firm and the founders are not sidestepped (Core & Larcker 1999). The business environment in which a firm operates is one of the determining factors when it comes to the formulation of performance-oriented remuneration contract (Core & Larcker 1999). It is viewed to be an internal mechanism to shield the interests of the shareholders. Substitution connections between external and internal mechanisms that aim at reducing the agency costs must be factored in while drafting contracts (Chalmers & Stapledon 2006). It is not easy to formulate a contract in which the remuneration of the top executive falls when performance falters. Such a move can risk the shareholders more that the chief executive. There is an emerging trend in which the principle shareholders nominate their associates to the position of top executives (Goldberg & Idson 1995). This move is supposed to cause the top executives to act in the best interest of their nominator to minimize the agency problems. Performance-sensitive contracts must be accompanied by other efficient methods of control and monitoring. The top executive must be motivated to improve assets and indeed the value of the firm. The firm can make profits but fall short of utilizing its full potential. Most of the top executives act to increase profits and shareholders’ welfare. The remuneration of the top executives is determined after weighing multiple options. Risk dispersal between the top executive and the firm’s shareholders is a sensitive issue (Hallock 1998). Remuneration of the top executives is seen as a strategy to make a firm competitive as opposed to a mere act of paying an employee (Goldberg & Idson 1995). Organizational strategy aims at increasing the value of a firm (Hallock 1998). Most of the previous researches have not shed light of the connection between the organizational assets with top executive remuneration (Fleming &Stellios 2002). This calls for further research into the impact of a chief executive in both the assets and the net-value of a firm. Top executives must lay a firm foundation for long-term profitability of firms and strategies of increasing the value. Research shows that executive remuneration and ownership structures of a firm are connected (Fleming & Stellios 2002). According to Pushner, control of a firm by the stakeholders and the owners at the in place of an independent executive can isolate a firm from market forces (Core & Larcker 1999). This also reduces the ability a firm to cope with unforeseen crises. Executive remuneration has an impact to the value of a firm (Hallock 1998). However, the previous research has been scanty in quantifying the impact (Jones & Kato I996). Many factors come to play when determining executive compensation. Shareholders use the performance contract as a guarantee for their interests (Jones & Kato I996). However, the research on the factors that determine executive compensation is not exhaustive. For the past decade, the corporate world has been faced by the contract market dynamics arising from globalization and technology (Jones & Kato I996). This calls for contemporary research of the modern determinants of executive remuneration and their impact on return of asset. According to Chalmers & colleagues (2006), executive compensation is associated with return on assets in all components apart from shares. The bonus component of the executive compensation appeared to be associated with annual stock market returns (Hallock 1998). The executive cash bonus had a positive association with accounting and market returns. According to Fleming & Stellios (2002), there is no relationship between firm performance and executive remuneration. Kubo argues that there is an undeniable connection between executive remuneration and firm performance. Return on equity is used to show firm performance in academics of compensation of executives (Jones & Kato I996). Annual stock market return and return on assets (ROA) are measured by EBIT/total assets annually in the United Kingdom. According to Jones & Kato (1996), return on assets can be defined as gross profit over total assets. Research shows that profit is better when it comes to assessing the performance of executives than sales (Chalmers & Stapledon 2006). Executive remuneration is also determined by power and the number of years the executive has served in the firm (Jones & Kato I996). According to Hill & Phan (1991), the tenure and age have little effect on executive compensation. Research shows that there is no consensus on the relationship between executive compensation and tenure. According to the report of the Department for Business, Innovation and Skills (BIS) a ministerial department of the United Kingdom Government, it is going to be prudent for companies to reveal how much the top executives earn. This is going to be considered in the upcoming executive remuneration and firm performance report. The proposal concerning executive remuneration suggests that the law must compel the executives to perform regardless of the remuneration. The majority feel that the haphazard rise in executive pay is misguided. However, some of the views given in the report fail to capture the views and worries of stakeholders. According to research, the stakeholders use the executive pay and incentives to ensure that the executive is committed to the welfare of organizational stakeholders. The elements of executive pay shall be part of the upcoming policy. The law is supposed to ensure shareholders and employees views are considered before setting up the executive pay. The opinions of the shareholders and employees shall be ratified in the organization’s annual general meeting. This shall be entrenched in the future policy that shall be subjected to vote. According to the BIS and government report, the salaries of the directors shall have to be proportional to that of employees’. The government sponsored enterprise and regulation bill demands that directors and executives must be accountable to employees and shareholders. The bill is expected to be signed into law by October 2013. This is after it wins the support from a substantial majority. Chapter 3: METHODOLOGY Methodology is typically a system of guidelines for figuring out a problem that consists of specific elements such as tasks, phases, tools, techniques, and methods. Methodology can also be described as the analysis of the principles of rules and methods used by a discipline. It can be perceived to comprise of several methods all of which are applied to different aspects of the entire scope of the methodology. The research shall use linear regression analysis to develop the data outcomes and trends. 3.1. Research approach The methodology can be categorized into two basic parts: qualitative research approach and quantitative research approach. Lance (2008) defines qualitative methods of research as “an array of interpretive techniques, which seek to describe, decode, translate and otherwise come to terms with the meaning, not the frequency, of certain more or less naturally according phenomena in the society world.” Nearly all research will encompass some numerical data that could helpfully be quantified to assist your answer, your research questions and to fulfil your major aims (Lance, 2008). Quantitative data refers to all those data and can be a product of various research strategies. This approach of method is a simply way to accumulate appropriate data from a considerable numbers of samples. While researching in the field of executive compensation and firm performance, it became apparent that the best approach is to use the quantitative methods of research as the very nature of such a research requires a vast amount of varied sources and details. Thus it is necessary to analyse it numerous studies completed on pay of chief executive officers in mining industry to establish the correlation between the remuneration of the executives and firm’s performance. The analysis will use firm’s performance indicators such as () as measures to determine whether the levels of executive remuneration affect firm’s performance. 3.2. Data collection and analysis Descriptive statistics will be used to analyse the data collected from different sources. This will also involve content analysis as the validity and applicability of data depends on how carefully the instruments have been constructed. Such an analysis helps in ensuring that what is supposed to be measured by the instruments is - measured precisely and obtained. The data from the mining companies will be analysed using the SPSS software to establish the relationship between the executive officers’ pay and performance of the firm. 3.3 Limitations 3.3.1 Validity Validity is the degree of accuracy and reliability arrived at in the process of research and manipulation of data. It entails defining the data and measures of collecting data. Constructive, predictive and content validity are enforced in the process of data collection. The assessment of content between individual concept and items define the dependability of standard research. The content validity was consistent with literature review and the use of instruments used in previous researches. Reliability indicates how the data was collected and measured. As only published, previously verified and reputable sources will be used for the purpose of this study it begs to believe that the outcome will be fairly accurate one. 3.3.2 Time scale Preliminary preparations of the research shall take two weeks. This shall involve preparing for the research and giving the data collection skills. In total, the entire project shall take 2 to 4 months. 3.3.3. Secondary sources of data: A data will be collected from secondary sources such as annual reports (for the last five years) of the mining companies listed on London Stock Exchange and Bloomberg data base. References Bebchuk, L. A., & Jesse, M. 2003. Executive Compensation as an Agency Problem. Journal of Economic Perspectives, 1,7, 71-92. Chalmers, K., & Stapledon, G. 2006. The determinants of CEO compensation. Rent extraction or labour demand? The British Accounting Review, 38, 1, 259–275. Charles, L. 2008. 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