Determinants of Return-Maximizing CEO Equity & Cash Compensation Determinants of Return-Maximizing CEO Equity & Cash Compensation

While the literature appeals to efficiency arguments from agency theory to explain the relative rise of CEO equity compensation, prior work has given less focus to CEO pay contracts based on equity and cash incentives that directly (analytically) maximize the total return of firm owners. The extended agency framework differs in that the principal’s objective function is the total shareholder return (inclusive of profits and associated gain in market value) and CEO equity and cash incentives are determined jointly taking account of the noisy market valuation relationship between firm income measures and value. We find that CEO cash incentives related to firm business performance (e.g., profits) are larger than equity incentives in the return-maximizing contract and both incentives increase with firm growth prospects and CEO productivity while business risk increases CEO equity incentives and decreases cash incentives. Further, the cash-only contract dominates the equity-only contract when firm equity risk exceeds business risk while the joint incentives contract generates the highest level of CEO effort. Overall, given the prevailing dominance of CEO equity compensation, the model and numerical study show that CEO cash incentives linked to firm business performance play a critical role in maximizing shareholder returns