Managerial Incentives for Risk-Taking and Internal Capital Allocation

Transcription

1 - Managerial Incentives for Risk-Taking and Internal Capital Allocation Ja Young Suh * School of Finance and Economics University of Technology, Sydney This draft: 13 January 2011 ABSTRACT It is commonly believed that managerial decisions regarding allocation of limited resources across various lines of business are critical to the value creation of a diversified firm. In this paper, for a sample of 551 diversified firms from 1992 to 2006, we explore managerial risk-taking incentives and its impact on stock price with respect to the intensity of internal capital allocation activities (i.e., active versus passive). We argue that the option-like structure of equity-based compensation encourages managerial risk-taking, and provide new evidence on the way in which CEO s risk-taking could manifest itself in a diversified firm. Our results show that a greater sensitivity of managerial compensation to shareholder wealth as proxied by CEO s portfolio vega leads to greater risk-taking through active capital allocation. We then analyze the impact of the risk-taking on shareholder wealth, and demonstrate that risk-taking does not result in a reduction in future stock price. Overall, this paper contributes to the literature by providing evidence that equity-based compensation does actually promote the alignment of interests between shareholders and managers. The convexity of equity-based compensation encourages CEOs to take more risk through a proactive allocation of resources. At the same time, the simultaneous impact of stock price on CEO s equity-related wealth and shareholders wealth prevents CEOs from engaging in strategies that recklessly increase risk and destroy firm value. Key Words: Risk-taking, Equity-based compensation, Internal capital allocation EFM Classification Codes: 150, 190 * School of Finance and Economics, Faculty of Business, University of Technology, Sydney, PO Box 123 Broadway NSW Australia 2007, Tel: +61 (2) ; address: jayoung.suh@uts.edu.au. I am grateful for valuable comments from my supervisor Terry Walter. I acknowledge the comments and suggestions from Susan Thorp, Balasingham Balachandran, and seminar participants in FIRN Doctoral Tutorial 2010 and Conference on Asia-Pacific Financial Markets All errors are my own.

2 INTRODUCTION It is commonly recognized that managers have discretion in making investment and finance decisions that influence firm risk, and that they are more risk-averse than shareholders since they are undiversified with respect to firm risk. Since they may be exposed to significant risks resulting from human capital being vested in the firm (Amihud and Lev, 1981; Smith and Stulz, 1985) and/or perquisite benefits (Williams, 1987), it is likely that managers become reluctant to take up risk-increasing projects even if they are expected to produce profits, unless they are compensated for bearing such risk. In the 1990s, equity-based compensation was introduced to alleviate such managerial risk-averse behavior by granting managers stocks and stock options. In this study we analyze the impact on managerial risk-taking of equitybased compensation contracts by looking at CEOs capital budgeting decisions within diversified firms. As a result, this paper makes significant contributions in the literature on both executive compensation and internal capital markets. First, we provide evidence that equity-based compensation, particularly stock options, improves the alignment of risk-taking interests between shareholders and managers. In particular, CEOs with a greater sensitivity of their equity-related wealth to stock volatility do increase firm-specific risk, which is consistent with interests of shareholders. To date, the literature has been inconclusive as to whether executive stock options promote managerial risk-taking. Some scholars have argued that stock options do motivate risk-taking since stock options increase in the volatility of the underlying stock while providing at the same time a protection to managers against bad outcomes (Smith and Stulz, 1985; Guay, 1999; Cohen, Hall and Viceira, 2000; Rajgopal and Shevlin, 2002; Coles, Daniel and Naveen, 2006; Low, 2009). Other studies instead have advocated that stock options would create incentives for managers to work more diligently, but the extent of risk-taking ultimately depends on the level of managerial risk-aversion and managers wealth at stake in the firm. According to this view, a stock option may even represent a deterrent to managerial risk-taking (Hirshleifer and Suh, 1992; May, 1995; Ju, Leland and Senbet, 2002; Lewellen, 2006). Second, we document new evidence on how CEOs increase their exposure to risk within diversified firms, by looking at the intensity of their active internal capital allocation. We show that the more sensitive the CEOs wealth to stock volatility, the more actively they shift available funds across the different segments of the firm. To the best of our knowledge, no previous study has specifically examined the channels through which managerial risktaking could be implemented as a response to the particular compensation structure selected

3 - 3 within a diversified firm. In fact, while the area of internal capital markets and its efficiency have been extensively investigated [see (Stein, 1997; Khanna and Tice, 2001; Maksimovic and Phillips, 2002; Billett and Mauer, 2003; Guedj and Scharfstein, 2004) for analyses on efficient internal capital markets, and (Shleifer and Vishny, 1989; Lang and Stulz, 1994; Berger and Ofek, 1995; Lamont, 1997; Shin and Stulz, 1998; Scharfstein, 1998; Rajan, Servaes and Zingales, 2000) for analyses on inefficient internal capital markets], only a few studies have presented an analysis of the impact of equity-based compensation on CEOs capital budgeting decisions (Yong, 2005; Datta, D Mello and Iskandar-Datta, 2009), leaving the critical issue of managerial risk-taking still unexplored. Our sample is composed of 551 diversified firms in Compustat for which we have available compensation data in Execucomp over the period from 1992 to We investigate to what extent the convexity of stock option (i.e., sensitivity of managers equityrelated wealth to stock volatility) influences managerial risk-taking in a diversified firm and the implications of this risk-taking on shareholders wealth. Since CEOs in a diversified firm are generally responsible for allocating capital across segments to the most promising investment projects, an analysis of diversified companies provides an ideal setting for us to explore both the dynamics of managerial risk-taking incentives and its consequent effects on firm valuation. For this purpose, in this study we decided to employ the measures of internal capital allocation proposed by (Guedj, Huang and Sulaeman, 2009). Guedj et al. introduce several proxies for internal capital allocation to capture the level of activeness of CEOs in diversified firms. They show that more active firms (those where yearly capital allocation to segments deviates substantially from benchmark allocations) significantly underperform passive firms (those where yearly capital allocation to segments largely mimics benchmark allocations) in the subsequent period. In this study, we begin by first analyzing what are the factors behind such active internal capital allocations and argue that risk-taking incentives implicit in equity-based compensation influence active/passive capital allocation. Our hypothesis hence is that CEOs with more convex equity-based compensation that is a higher sensitivity of equity portfolio value to stock volatility are more likely to engage in active internal capital allocation with the aim to increase firm risk. To test this hypothesis, we employ the semiparametric fixed-effects censored model developed by Honoré (1992) in order to account for the fact that the activeness measures are censored between zero and one by construction (Guedj et al, 2009). Our results demonstrate that this is indeed the case: the convexity of

4 - 4 managerial compensation (i.e., change in the value of managers equity-related portfolio in response to a change in stock-return volatility measured by CEO s portfolio vega) is positively related to the level of CEOs activeness in internal capital allocation. To the extent that well-diversified shareholders prefer more risk-taking to less (this is one of the primary purposes for structuring convex payoffs to managers) ceteris paribus, our results provide convincing evidence that the convexity of equity-based compensation does indeed promote the alignment of interests between shareholders and managers. Next, we show that using pooled OLS regressions with double clustered standard errors which correct for non-constant volatilities and autocorrelations the active internal capital allocation originated from risk-taking incentives is positively associated with an increase in firm risk in the subsequent period. Consistent with prior studies, we use equity risk as a proxy for firm risk (Low, 2009; Shin and Stulz, 2000). The use of equity risk as a proxy for firm risk seems reasonable given that an executive stock option is written on a firm s stock. Therefore, it enables us to better understand the direct impact of executive compensation on managerial risk-taking behavior. In particular, we look closely at the idiosyncratic component of stock volatility because it is that part of risk which is entirely specific to a firm s operations. Lastly, we investigate the implications for shareholder value of this risk-taking. Specifically, using pooled OLS regression we test whether risk-taking through more active internal capital allocation creates value by calculating the future performance of active firms. The results show that activeness driven by risk-taking motives does not lead to underperformance. The remainder of the paper is organized as follows. In section 2, we discuss in detail the literature closely related to this study and introduce our research questions. In section 3, data and sample summary statistics are provided followed by results in section 4. Section 5 concludes. 2. RELATED LITERATURE AND HYPOTHESES 2.1 Managerial Incentive for Risk-Taking Early studies on agency theory such as (Jensen and Meckling, 1976; Holmstrom, 1979; Grossman and Hart, 1983) suggested that managerial compensation should be tied to some observable performance measures such as market returns or profitability ratios so as to encourage managers to make value-maximizing decisions. A possible drawback of such an approach is that these output measures are conditional on random factors that could be

5 - 5 beyond agents control, consequently exposing agents to significant income-risk. As a result, risk-averse managers would be unwilling to take up riskier investments irrespective of their positive NPV (Amihud and Lev, 1981; Smith and Stulz, 1985; Williams, 1987) and irrespective of shareholders preferences. One way to reduce such managerial risk-aversion (i.e., the concavity of managerial utility function) is to provide managers with a convex payoff structure comprising stock options as part of their compensation. In theory, this is expected to motivate risk-taking as profits progressively accrue to managers when a firm flourishes (given that a stock option value increases with stock price), while at the same time protecting managers against possible losses. Guay (1999) shows that stock options play a significant role in increasing the convexity of the relationship between the wealth of shareholders and that of managers, where the convexity is measured as the change in the value of managers portfolio (composed of stock options and stocks) in response to a change in stock-return volatility. He shows that stock returns become more volatile as the convexity increases. (Cohen, Hall and Viceira, 2000) also find that the higher the convexity the higher the level of firm leverage and stock return volatility. Rajgopal and Shevlin (2002) study oil and gas production firms, and show that risk-taking incentives increase oil exploration risk. Coles, Daniel and Naveen (2006) further show that the convexity leads to riskier investment and financing policies. Managers with a greater convexity in managerial compensation tend to concentrate capital in fewer segments, increase firm leverage, and increase investment in R&D, but decrease capital allocation in low-volatility sectors such as property, plant, and equipment. More recently, Low (2009) provides evidence of managerial risk-taking in the presence of an exogenous shock to a firm a shift in Delaware takeover regime during the mid-1990s which dramatically increased the shareholder protection of target firms. She shows that managers of Delaware-incorporated firms on average reduce firm risk by about six percent, and that this risk-reduction is mostly concentrated in those firms where CEO s portfolio vega is low. Overall, these studies argue that convexity results in more risk-taking, and hence equitybased compensation works as an effective tool to properly mitigate the misalignment of risktaking interests of shareholder and managers. However, other studies document evidence that equity-based compensation, in particular, a stock option, may work as a deterrent to managerial risk-taking. They argue that while the sensitivity of CEOs option portfolio to change in stock price (i.e., stock option delta) would provide CEOs with strong incentives to work harder to boost the stock price, it

6 - 6 also makes CEOs concerned about a negative impact on their stock options resulting from a decrease in stock price. According to this view, the possible net effect is that equity-based compensation could even intensify managerial risk-aversion. For example, Knopf, Nam Jr. and Thornton (2002) show that the sensitivity of equity-related managerial wealth to a change in stock price (i.e., delta) increases derivative usage (i.e., reduce risk), while the convexity of managerial compensation (i.e., vega) exhibits a negative relation. The bottom line is that the convexity does not automatically translate into managerial risk-taking since the degree of risk-taking also depends on managerial risk-aversion and the impact of stock price on the value of stock options. Pushing this reasoning further, equity-based compensation could even lead managers to an extremely conservative or aggressive risk-taking (Hirshleifer and Suh, 1992; Ju, Leland and Senbet, 2002). Managers could also be inclined to reduce firm risk in order to decrease the risk of personal wealth vested in the firm (i.e., human capital income and perquisite benefits accompanied by the position) through diversification. Amihud and Lev (1981) find that conglomerate mergers are mostly driven by the aim to reduce risk for reasons related to managerial personal wealth at stake. May (1995) also shows a greater tendency of CEOs to diversify in corporate acquisitions as they have more personal wealth vested in the firm. The rationale for risk-reduction rests on the limited possibility for managers to diversify risks. Contrary to well-diversified shareholders, managers can reduce their personal exposure to risk only by decreasing firm risk, for instance, through corporate diversification. Lewellen (2006) demonstrates that the moneyness of stock options influences managerial risk-aversion and risk-taking. In particular, in-the-money stock options demotivate risk-taking as in-the-money options would make managerial wealth more sensitive to stock price movement, leading managers to be more risk-averse. On the contrary, when CEOs have out-of-the-money options, risk-taking would become more attractive to them as the option value is protected against downside movement of the underlying stock price. There are differing views on the implications of equity-based compensation on shareholder wealth. Daniel, Martin and Naveen (2004) argue that, if equity-based compensation induces greater managerial risk-taking, shareholders would end up being worse off in those instances where high-risk projects selected by managers do not return a positive NPV. Any additional risk taken by the managers would then be transferred from shareholders to bondholders. Firms offering higher equity-based incentives to managers would therefore face a higher cost of debt as bondholders perception of these firms being riskier would be

7 - 7 reflected in the required cost of debt. 2 The possible consequence is that even if these firms have higher expected stock returns ex ante, they would generate lower abnormal returns expost when compared to those firms with lower equity-based incentives. Nevertheless, Cohen et al. (2000) find that the market reacts neither negatively nor positively to managerial risktaking. Low (2009) also claims that equity-based compensation is likely to mitigate the conflict of interests between shareholders and managers, and document evidence that equitybased compensation positively contributes to shareholder wealth. She demonstrates that risk reduction negatively impacts shareholders wealth and that this risk reduction is mostly prevalent in firms with low option vega. 2.2 Internal Capital Markets and Managerial Incentives A firm is commonly classified into two categories a diversified firm and a stand-alone firm depending on the number of business segments composing the firm. A diversified (standalone) firm is any firm with a number of segments more than (equal to) one segment, where a segment is defined as an identifiable part of a business or enterprise. 3 A large number of studies examine cross-subsidization and interdependence across various divisions in a diversified firm, and claim that a diversified firm has an internal capital market in which the firm actively allocates capital across various business segments. As a consequence, the investment of one division is inseparable from the cash flows of other divisions (Stein, 1997; Lamont, 1997; Shin and Stulz, 1998; Williamson, 1975; Lang, Ofek and Stulz, 1996; Houston, James and Marcus, 1997). 4 However, it still remains a controversial issue whether or not internal capital markets are efficient, and if not, what are the sources of such inefficiency. First, proponents of efficient internal capital market contend that corporate headquarters of a diversified firm could add value by actively allocating capital by picking the winners and losers with 2 Kuang and Qin (2009), for example, document evidence that credit rating agencies take into account managerial risk-taking incentives implicit in firms compensation structure and adjust firms credit ratings accordingly. 3 In this study, the terms, a diversified firm, a conglomerate firm and a multi-segment firm are used interchangeably, and so are a (business) segment, a division and a line of business. A stand-alone firm or a focused firm will be used in exchange of a single-segment firm. 4 Internal and external capital markets are two of the channels through which capital is allocated across various industries. The difference is that, while in external capital markets an increase (decrease) in capital allocation in certain industries occurs through constituent firms issuing equity and debt or participating in share repurchases, individual firms contribute in internal capital market to the industry capital allocation by varying the level of the capital expenditure across different industrial segments within the same firm.

8 - 8 individual divisions competing against each other for scarce capital (Stein, 1997). Second, internal capital markets provide greater financial flexibility to diversified firms. As a result, firms could subsidize a segment which would otherwise have difficulty to finance promising projects if it were a focused firm (Billett and Mauer, 2003). Also, Khanna and Tice (2001) find that diversified firms tend to cope better with negative shocks to the firm than focused firms. Third, diversified firms can exploit comparative advantages between segments in allocating resources (Maksimovic and Phillips, 2002), and avoid overinvestment in a particular segment (project) due to a lack of alternative ones (Guedj and Scharfstein, 2004). In contrast, various theories have been put forward in favor of inefficient internal capital markets. Some argue that overinvestment which results from abundant internal cash flows combined with managerial entrenchment (Shleifer and Vishny, 1989; Jensen, 1986) often lead to inefficient internal capital allocation. Instead, Scharfstein (1998), Rajan, Servaes and Zingales (2000) and Scharfstein and Stein (2000) postulate that power struggles among divisional managers wishing to get hold of larger capital budgets (labeled as socialism ) in addition to the agency problem between shareholders and headquarter managers may distort internal capital markets. Sharfstein (1998) further argues that resolving agency problems at the top management level perhaps through effective incentive awards is, after all, the key to improving efficiency of internal capital allocation. His evidence indeed shows that inefficient capital allocation allocation of resources irrespective of segments investment opportunities is drastically reduced as the level of equity ownership of top management increases. Despite the significant role of agency problems in internal capital market, the impact of managerial incentives, or executive compensation, on diversified firms has not received much empirical attention. To date, only a few studies have surveyed the direct implication of managers incentive schemes on their decisions related to internal capital allocation. Yong (2005) shows that managers tend to make internal capital allocation decisions in a way that increases managerial private benefits. A greater proportion of a firm s capital expenditure seems to be allotted to segments which are part of industries with a higher level of average executive compensation. Especially, when firms eliminate (add) segments, this managerial decision is most likely affected by whether the segment s industry has a lower (higher) average CEO compensation. However, equity-based compensation could be an effective route to mitigate potential self-dealing of managers. Datta, D'Mello and Iskandar-Datta (2009) investigate the impact of

9 - 9 equity-based compensation on the efficiency of internal capital allocation of a diversified firm. The premise is that managers are less likely to make value-reducing investment decisions if the cost of such decisions is greater than the private benefits potentially obtained by managers from misallocating capital. Their results show that the greater the sensitivity of CEO s equity-related wealth to firm value measured as CEO s portfolio delta and vega, the more efficient the firm s internal capital allocation. 2.3 Hypotheses Guedj, Huang and Sulaeman (2009) show that firms that actively move funds across segments significantly underperform passive firms in the subsequent period. This result is surprising since it implies major failures in internal and external corporate governance mechanisms in disciplining managerial behavior. Indeed, if active capital allocation destroys firm value, CEOs would not dare make bold active decisions that are value-reducing in the first place. Second, once CEOs realize that active capital allocation leads to poorer performance, they would immediately correct their decisions and become more jaded by passively allocating capital in the future. The result is that there would not be any active capital allocation within firms in the long-run. The question worth considering is related to the motivations behind CEOs activeness in capital allocation. We conjecture that risk-taking incentives induced by convex equitybased compensation may be playing a significant role in creating active internal capital markets. Our hypothesis therefore is that CEOs with more convex equity-based compensation (i.e., a higher sensitivity of equity portfolio value to stock volatility) would engage in more active internal capital (re-) distribution with the aim to affect firm risk. If a positive relationship between the convexity and the degree of activeness was detected, and the active internal capital allocation resulted in an increase in firm risk, it would be consistent with the theory that a high CEO vega promotes the alignment of interests on risk-taking between shareholders and managers. We summarize the first hypothesis as follows. H1: The higher compensation sensitivity to stock volatility leads managers to engage in more active internal capital allocation across segments.

10 - 10 Next, we investigate whether active capital budgeting ignited by greater risk-taking incentives influences firm risk. If it was true that CEOs attempt to increase firm risk via active capital allocation (thus creating internal capital market that has a higher default risk), then we should observe a positive relationship between the degree of activeness in internal capital allocation and firm risk in the subsequent period(s). As a result, the second hypothesis, H2, can be expressed as follows: H2: More active internal capital markets cause an increase in firm risk. If indeed there existed a positive correlation between the lagged degree of activeness and the level of firm risk, then the implications of H2 combined with that of H1, would be that CEOs of diversified firms with more convex equity-based compensation (i.e., higher CEO s portfolio vega) are more likely to exhibit risk-seeking behavior, and that this risk-seeking is pursued by more actively varying the level of capital expenditure to segments. Finally, we examine how active (passive) internal capital allocation triggered by managerial risk-taking incentives contributes to shareholder value. Indeed, given the convex structure of compensation, managers could gamble on the fluctuations of firm performance by selecting riskier investment projects without proper consideration given to the profitability of such projects, hoping that they would generate positive returns in the future (even by chance). However, we argue that the concurrent impact of stock price on both the value of CEOs stock options and the wealth of shareholders would prevent unnecessary and valuedestroying risk-taking. As a result, managerial risk-taking should be beneficial to both managers and shareholders. Therefore, our third hypothesis is summarized as follows: H3: Managerial risk-taking through active internal capital allocation has a positive impact on stock value. If more active firms were also better performing firms, then the higher compensation sensitivities (i.e., convexity) would be consistent with the alignment of interests between shareholders and managers. In this case, equity-based compensation serves not only as incentives for managerial risk-taking but also as incentives for making the best use of managers private information. Another possibility is that the active internal capital allocation does not have any impact shareholder wealth. Even so, the result would still be consistent

11 - 11 with the alignment of interests to the extent that a greater convexity of equity-based compensation alleviates managerial risk-aversion. 3. SAMPLE SELECTION AND SUMMARY STATISTICS 3.1 Sample Selection The segment data are sourced from the Segment and Industrial Annual file (both active and research) provided by CRSP/COMPUSTAT Merged (CCM) Database. Hence the sample in this study also includes firms that are subsequently deleted from COMPUSTAT due to mergers and bankruptcies. According to FASB-SFAS No.14 and SEC regulation S-K, publicly traded US companies are obliged to disclose, for every distinct business segment which constitutes more than ten percent of total sales, accounting data such as sales, assets, depreciation, capital expenditure, income, and operating profits since To begin with, we download the universe of segments reported by the Segment and Industrial Annual file provided by CCM Database over the period from 1991 to We remove segments which operate in agriculture and financial and services industries (i.e., segment SIC code less than 1000, and greater than or equal to 6000). Segments with incomplete data on capital expenditure, sales, depreciation, operating profits and SIC code are dropped. We also eliminate segments with zero depreciation, capital expenditure greater than sales, negative capital expenditure and negative assets. Firms sometimes report segments which do not have actual economic activities entitled as, for example, corporate adjustment, intersegment elimination, reconciling items and so on. Because the accounting data in these segments represent unallocated amount in sales, assets and operating profits, we also remove these noneconomic segments from our sample (Ahn, 2010). Finally, we exclude firms with sales less than $20 million. After the filtering process, we have 64,889 segment-firm-year observations. To be included in our sample of diversified firms, a firm needs to have a number of segments equal to or greater than two for at least two consecutive years. After imposing this condition, we have 21,189 segment-firm-year observations for diversified firms, and 29,728 firm-year observations for stand-alone firms over the period from 1992 to The executive compensation data are collected from the Standard and Poor s Execucomp database whose original source is a company s annual proxy (DEF 14A SEC form). The compensation data are available from 1992, and this is the reason why the sample period of this study starts from Execucomp provides detailed information of the top five (ranked by salary and bonus) executives (including the CEO) in a company on

12 - 12 compensation such as salary, bonus, stock and option awards, non-equity incentive plans and other compensation items. Execucomp mostly provides an indicator for a CEO every year. However, in rare cases of missing a CEO indicator, we regard an executive with the highest sum of salary and bonus as the CEO for that year (Yong, 2005). For the calculation of option sensitivities (described later in the methodology section), we obtain dividend yields and stock price volatilities from Execucomp. For the risk-free rate, we use Treasury yields downloaded from the US Department of Treasury website. 5 Stock prices and company annual fundamental data are downloaded from CRSP Monthly Stock File and COMPUSTAT North America Fundamentals Annual database, respectively. After we merge the compensation and the segment data, we have a sample of 551 diversified firms, or an unbalanced panel of approximately 3,612 firm-year observations over the period from 1992 to Main Variables Construction Measures of Activeness One of the main variables in this study is the measure of activeness in internal capital allocation. Guedj, Huang and Sulaeman (2009) recently introduce three measures which capture the activeness level by looking at how much a firm s capital expenditure in each segment in a particular year deviates from i) firm s past capital allocation (labelled as dlc), ii) capital allocation of stand-alone firms in industries to which each segment corresponds (labelled as dic), and iii) free-cash-flows that each segment generates (labelled as dsf). A dlc is calculated as the sum of the absolute fractional changes in capital allocation to each segment over two years and can be written as follows., 1 2,,,, where CAPX i,t is the capital expenditure allocated to a segment i of a firm f in year t, where set F includes segments which are reported for both years, t and t-1. As an example, assume that a firm has segments A and B in common over two years, t-1 and t. If the firm allocated 20% of total capital expenditure to segment A and 80% to segment B in year t-1, and (1) As a comparison, Datta, D Mello and Iskandar-Datta (2009) who study executive compensation and internal capital market efficiency have a sample size of 1,311 diversified firm-years over the period after imposing few additional filtering rules. The number of observations, 3,612 is a total number of firm-year observations of all firms for which we were able to calculate both an activeness measure, dlc in particular, and CEO s portfolio vega. However, due to unavailability of other firm characteristic data, the total number of observations used in regressions analyses is different.

13 - 13 equally distributed capital in year t, then the dlc t would be [ ]/2 (the sum of fractional capital expenditure changes over the two years in segment A and in segment B). The second, dic, measures the degree of activeness by quantifying the deviation of the capital expenditure allocated to a particular segment from corresponding industry s average capital expenditure over the same time horizon, which can be written as the following., 1 2,,,,,,,where,,, In calculating the growth factor, g i,t, we sum the capital expenditure of stand-alone firms (s) in the industry (I) where segment i belongs in year t. Then we subtract the synthetic capital expenditure (i.e., the product of the growth factor and segment capital expenditure in the previous year), which a segment would have received if the firm followed industry trends, from the current year s capital allocation. The last measure, dsf, takes segment s free-cashflow as a benchmark, and is defined as follows., 1 2,,,, where SF i,t-1 is a segment i s free-cash-flow (defined as the sum of operating profits and depreciation) in year t-1. 7 The dlc, dic and dsf are all positive as they take absolute values. The values lie between 0, in which case no change occurs in segment capital allocation relative to their benchmark, and 1, in which case a 100% change occurs in segment capital allocation, and hence one can interpret that the higher the dlc, dic and dsf, the more active the diversified firm s internal capital allocation activities. Typical executive stock option in the U.S. has a minimum vesting period of 12 months, after which a quarter of the award is exercisable and the rest of the award becomes exercisable in equal installments over the period of the next 3 years. Hence the average vesting period for a typical stock option plan is approximated to be 30 months or 2.5 years (Kole, 1997; Kato et al., 2005). Given this practice, we argue that the risk-taking incentives triggered by the convexity of equity based compensation would exhibit itself (via active internal capital allocation) over the long-time horizon so that an increase in risk can have actual impact on the wealth of CEO s stock option portfolio around the time at which his stock option becomes available for exercise. Therefore, we use moving-averaged internal (2) (3) 7 Following Guedj et al. (2009), we drop segments which have the sum of operating profits and depreciation less than zero.

14 - 14 capital allocation activeness measures over 3 year period which is the average vesting time for a stock option in the U.S., in our study Measures of CEO Risk-Taking Incentives As for the CEO risk-taking incentives, we calculate a vega of CEO s equity portfolio consisting of options and a delta of CEO s equity portfolio consisting of stock options and stocks. A number of studies measure managerial incentives using option delta (Cohen, Hall and Viceira, 2000; Core and Guay, 1999), option vega (Cohen, Hall and Viceira, 2000; Knopf, Nam Jr. and Thornton, 2002) or both (Rajgopal and Shevlin, 2002; Coles, Daniel and Naveen, 2006; Daniel, Martin and Naveen, 2004; Core and Guay, 2002; Rogers, 2002), where option delta is defined as the change in the dollar value of an executive s option portfolio with respect to a one percentage change in stock price, and option vega is defined as the change in the dollar value of executive s option portfolio with respect to a one percentage change in the annual standard deviation of stock returns. These studies show that other measures such as the number or the value of options held, the number of newly granted options, stocks held, or a combination of some of these are potentially noisy proxies for incentives faced by executives, and that option delta and vega characterize the managerial incentives more precisely. Following Core and Guay s approach (2002), we calculate the vega of CEO s option portfolio and the delta of CEO s stock and stock option portfolio. Guay (1999) demonstrates that option vega is substantially higher than stock vega, and hence the option vega is a sufficient measure to represent both stock and option vega (Coles et al., 2006). An option is priced using modified Black and Scholes (1973) s option pricing model (1973) which takes into account dividends (Merton, 1973). We calculate an option vega (delta) as a first order partial derivative of option value with respect to stock volatility (stock price). In particular, option vega (delta) is dollar change in the value of stock option given one percentage change in stock volatility (stock price). The mathematical expressions for the computation are attached in Appendix A. CEO s portfolio vega is the sum of the vegas of all options held by the CEO. CEO s portfolio delta is calculated as the sum of CEO option delta and CEO stock delta, where CEO stock delta is defined as a dollar change in CEO s portfolio consisting of stocks in response to one percent change in stock price. For pricing new option grants, Execucomp provides the necessary parameters in the Black-Scholes model. Following the method of option valuation employed by Execucomp,

15 - 15 we assume that options are granted on grant year s fiscal year end since the exact grant date is not available. The time-to-maturity of an option is reduced by 30% to an amount of 70% of the actual time-to-maturity (Core, Guay and Verrecchia, 2003). This is because executives often do not wait until the expiration date to exercise their options (Hemmer, Matsunaga and Shevlin, 1996; Huddart and Lang, 1996). We use volatility and dividend yield which are directly obtained from Execucomp, and Treasury bond yield matching the remaining time-tomaturity of the option is used as a risk-free rate. 8 For previous option grants, variables such as exercise price and time-to-maturity are not provided by Execucomp, and hence they need to be approximated using Core and Guay s one-year approximation method (2002). 9 For both unexercisable and exercisable options, we compute an average exercise price by subtracting realizable value scaled by number of options from year-end price, where a realizable value is defined as stock price less exercise price. The realizable values are disclosed in the proxy statement and can be accessed through Execucomp. The approximated time-to-maturity for unexercisable option is equal to the timeto-maturity of most recent year s option grant less one year. For exercisable options, we set time-to-maturity equal to the most recent year s unexercisable options. If there was no new grant made, time-to-maturity for unexercisable (exercisable) option is set to be nine (six) years. Once these parameters are approximated, we compute the vega of previously granted options using Black-Scholes option pricing formula. Several studies demonstrate that CEO s portfolio vega, rather than delta, is the one that provokes managerial risk-taking (e.g., Knopf et al.,2002; Kuang et al, 2009; Low, 2009). Since this study is concerned with the direct impact of managerial risk-taking incentives on internal capital allocation decisions, we focus on CEO s portfolio vega as a measure of risk-taking incentives and include CEO s portfolio delta as a control variable. 3.3 Summary Statistics 8 According to Execucomp, volatility is estimated based on the previous 60 month stock returns. If a stock has traded for less than 60 months, Execucomp uses as many months as possible to do the calculation. If the stock has traded for less than a year, it inputs the average volatility value for the S&P If stock volatility is unreasonably high (low) - outside 95 (5) percentile -, then the volatility is reduced (increased) to a 95 (5) percentile value. Also, if a dividend yield falls outside 95 percentile, it is reduced to a 95 percentile value. We take T-bill rate on the last day of each month. For unavailable T-bill rate as T-bill rate is available for periods such as 1-, 3-, 6-month, 1-,2-,3-,5-,7-,10-,20-,30-year, a linear interpolation method is applied (Bond Portfolio Management, Ch.9, p. 217, Frank J. Fabozzi). We use the logarithms of risk-free rate and dividend yield. 9 We thank Core and Guay for sharing their codes.

16 - 16 Panel A of Table 1 reports sample firm characteristics. All continuous variables are winsorized at 1 st and 99 th percentiles. Diversified firms in our study have, on average, a total asset of 7,028 million dollars and approximately three segments. We define a book-to-market ratio as a total book value of common equity to market capitalization, which is the product of share price and the number of common shares outstanding as of the fiscal year end. The average book-to-market ratio in our sample is , which show that the majority of our sample are growth firms. Average accounting profitability of the sample firms (measured as a return on asset defined as net income divided by total asset) is 4.46 percent. On average, the ratio of total capital expenditures to total assets is 0.06 and the growth rate of capital expenditure computed over three-year periods is about 15 percent per year. The Herfindahl index of capital expenditure is obtained by calculating the sum of squared ratios between each segment s capital expenditure and total capital expenditure, and it proxies for the concentration of capital in particular segments. The average Herfindahl index is On average, the leverage ratio of sample firms is 0.27, where the leverage ratio is computed as the sum of long-term and short-term debt divided by total assets. Altman s Z-score (Altman, 1968; ) is calculated using the following formula (4) where X 1 = working capital/total asset, X 2 = retained earnings/total assets, X 3 = earnings before interest and taxes/total assets, X 4 = market value of equity/book value of debt, and X 5 = sales/total assets. Firms with Z-score above 3.0 are considered to be financially stable while those with Z-score below 1.8 are considered to have a very high risk of going bankrupt. Firms in the sample have average Z-score of 3.33, indicating that the firms in our sample have generally favorable financial prospects. Average stock return during a fiscal year is approximately 16 percent. Panel B of Table 1 reports the summary statistics of the activeness measures, DLC, DIC and DSF, the three-year moving averages of dlc, dic and dsf that are defined in section DLC has a mean of approximately 0.10, and a standard deviation close to Firms in our sample show relatively lower DLC values compared to that of Guedj et al. (2009) which has mean value of The difference seems to occur due to the fact that our sample consists of diversified firms that have compensation data available in Execucomp whose universe of firms includes mostly large firms S&P500 firms from 1992 to 1994 and S&P 1500 companies. Given the evidence of Guedj et al. that the smaller the more active, it is not surprising that DLC is lower for our sample firms which are mostly large firms due to

17 - 17 merging of two databases. DIC, which adjusts for industry capital allocation, displays very similar statistics to DLC. On the other hand, the mean and the standard deviation of DSF are much higher than those of the other two measures. In panel C, we report the correlations between the activeness measures and other firm characteristics. The correlations in absolute value range from a minimum of 0 to a maximum of Notice that the correlation between DLC and DIC is as high as 0.94, while DSF s correlations with DLC and DIC are relatively low. Guedj et al (2009, p11) state that DSF inherits by construction volatile nature of cash flow and captures very different aspects of the capital allocation process to DLC and DIC. Therefore, it is not so surprising to observe different characteristics for DSF and low correlations. This in turn leads us to have different results based on DSF often tend to produce inconsistent results. Hence our study hereafter will focus on the measures which are not influenced by the volatile segment free-cash flows, which are DLC and DIC measures. In Table 2, we provide the summary statistics of CEO compensation. Total direct compensation includes salary, bonus, total value of stocks granted, total value of stock options granted, long-term incentive payouts and other annual compensation variables. Cash compensation is the sum of salary and cash bonus. In our sample, CEOs on average received a total compensation of approximately 3.6 million dollars of which approximately a third is paid in cash. As previously documented in the compensation literature, the distribution of CEO compensation is positively skewed. Panel B of Table 2 provides annual averages of CEOs total/cash compensation, portfolio vegas and deltas. The dollar values are adjusted for inflation and expressed in dollars in To better understand yearly trends in compensation, we provide graphs for the values provided by Panel B of Table 2. Figure 1 depicts the annual average CEO compensation and average sensitivities of the CEO s portfolios of the sample firms over the sample period While total cash compensation remains relatively constant, CEO s total direct compensation increases significantly over the sample period. This supports the well-known evidence of the explosive use of equity-based compensation since the 1990s. As seen in Graph B, CEO s portfolio vega generally tends to increase towards 2002, and then decrease thereafter. On the contrary, it is quite difficult to discern a general tendency in CEO s portfolio delta. Certainly the annual average deltas after the end of the 1990s are higher than the previous periods with its peak reaching approximately 1.4 million dollars in Summary Statistics of Quintile Portfolios

18 Financial Characteristics of Quintile Portfolios sorted by Activeness We first provide the statistics of financial and compensation characteristics of each quintile portfolio formed on sorted DLC (i.e., deviation from lagged capital expenditure). The portfolio approach serves not only as a useful check that our computation of DLC is qualitatively similar to that of Guedj et al. (2009), but also as a good starting point to understand the non-linear relationship between DLC and other firm characteristics. Panel A of Table 3 reports the company characteristics of quintile portfolios sorted on activeness measure, DLC. Active firms tend to be small in size and value firms compared to other firms in the sample based on sales and book-to-market ratio. Active firms also have more segments than passive firms, a lower asset-adjusted capital spending, a lower profitability as measured by ROA, and a less concentrated capital proxied by the Herfindahl index of segment capital expenditure. Rajan, Servaes and Zingale (2000) assert that the discrepancy in investment opportunities among segments affects managerial decision to allocate resources. We first calculate Tobin s Q of all single-segment firms where Tobin s Q is defined as total assets minus book value of equity plus market value of equity, which is then scaled by total assets. We then assign to each segment of a firm the beginning of year s asset-weighted average of Tobin s Q of single-segment firms which operate in the same Fama-French 48 industry as the segment. A standard deviation of segments Tobin s Qs then represents the dispersion in investment opportunities across segments. 10 Active and passive firms show a similar level of the dispersion in segments investment opportunities. Also, no particular difference between active and passive firms is detected with respect to leverage - the sum of long-term and short-term debt divided by total asset, and financial distress proxied by Altman s Z-score (1968). Although the differences between active and passive firms in the growth rate of asset and capital expenditure are significant, the mean values of these variables in each portfolio seem quite volatile, showing little pattern. The characteristics of the portfolios sorted on DIC (i.e., deviation from industry capital expenditure) shown in Panel B in Table 3 are very similar to that shown in Panel A except for total asset and dispersion in segment investment opportunities Risk Characteristics of Quintile Portfolios sorted by Activeness 10 Variables which require industry matching with stand-alone firms - dispersion in segment Q, industryadjusted ROA and Tobin s Q, and industry-adjusted activeness measure (dic) are calculated only if a segment has at least five stand-alone firm matches based on Fama-French 48 industry classification. If any of the segments has less than five stand-alone firm matches, we define these variables as missing. Approximately 13% of the firm-year observations for which we were able to calculate dlc fall in the criteria.

19 - 19 Next, we examine risk characteristics of quintile portfolios sorted on activeness. As a measure of stock risk, we calculate betas and idiosyncratic volatilities based on three widely used asset pricing models - Capital Asset Pricing Model (CAPM), Fama-French 3-factor model (1993), and Carhart 4-factor model (1997). Each model is estimated using a 36-month rolling window. A beta is the coefficient on Rm-Rf, and idiosyncratic volatility is an annualized standard deviation of the residuals over the previous 36 months as of the end of June every year. Panel C of Table 3 shows that, except for the beta from CAPM, betas and idiosyncratic volatilities increase almost monotonically as the degree of activeness measured as DLC intensifies. The differences in risk levels between active and passive portfolios are statistically significant at 1 % level. This raises the question of what drives managers to actively re-allocate available funds across segments thereby increasing firm exposure to higher risk. We conjecture that the equity incentives provided via stock options influence managerial decisions (at the corporate headquarter level) on internal capital allocation of a diversified firm. As the payoff of CEO stock option increases with stock volatility, while managerial wealth is protected from any downside risk given the convexity of a call option (holding other variables which determine the value of a call option equal), CEOs would be incentivized to invest in high-risk projects. Given the evidence that stocks with more active internal capital markets have significantly higher risk, we argue that managers with a higher sensitivity of equity-based compensation to stock volatility (measured by CEO s portfolio vega) are more likely to engage in active internal capital (re-) distribution in attempt to increase firm risk. We investigate this issue using multivariate regression models in the next section. 4. RESULTS In this section, we use multivariate regression models to test our hypotheses. We first test H1 and H2 which predict that higher compensation sensitivity to stock volatility leads managers to take higher risk by engaging in more active internal capital allocation. The presence of positive relations between the CEO s portfolio vega and the degree of activeness, and between activeness and firm risk would indicate that the more convex the equity-based compensation the greater the managerial risk-taking. We first show that greater risk-taking incentives resulting from higher CEO s portfolio vega lead CEOs to more actively engage in internal capital allocation (Test of H1, Section 4.1). We then move to test if CEO s decision to actively re-allocate capital indeed results in an increase in firm risk (Test of H2, Section