The Nonlinear Effect of Executive Compensation on Financial Performance

Abstract

The agency theory propagates the use of compensation as a motivational measure to get the interest of the firm’s owners and the managers aligned. However, after a series of scandals, there has been a widespread focus on the payments made to the executives and their relationship with the organization’s financial performance. Although the relationship between compensation and performance has been observed extensively, the change in the relationship at various levels of compensation and the nonlinear aspect in the relationship still remain unanswered. Under this backdrop, the study makes an in-depth analysis of the relationship between executive compensation and firm performance in the context of 182 nonfinancial NSE-listed companies of India for the period 2014–2020. The study besides applying the static panel data analysis also advances to generalized method of moments based dynamic panel model to overcome the issues of endogeneity and declares that the relationship existing between executive compensation and firm’s Tobin’s Q is seen to be an inverted U-shaped curve. As per the robust estimator, an increase in the level of executive compensation is found to affect financial performance positively until it transcends a threshold level of 2.6% of the firm’s net profit.