Investment Opportunities and the Structure of Performance-Based Executive Compensation

Abstract

The contracting paradigm advanced in Smith and Watts (1992) suggests that both the risk-sharing and incentive consequences of performance-contingent compensation depend on the extent that investment opportunities comprise firm value. Following Smith and Watts we hypothesize that sensitivity of CEO compensation to measures of firm performance varies directly with future investment opportunities. We also hypothesize that investment opportunities promote the use of market-based rather than accounting-based performance measures. Results using 1992- 1993 compensation paid to 1249 CEOs of publicly-traded U.S. firms are consistent with these hypotheses.

JEL Classification: J33, M49