Agency costs of free cash flow and the CEO pay-performance relationship: some evidence on the role of CEO characteristics

Exorbitant chief executive officers' (CEOs) compensation and weak pay-performance relationship has been widely criticised as abuse of managerial power and the intrusion of agency problems. This study examines whether firms with agency problem of free cash flow (FCF) identified by Jensen (1986) influence the CEO pay-performance relationship. The FCF hypothesis suggests that firms with low growth opportunities and excess funds dilute managers’ incentives to improve firm value by providing them the opportunity to indulge in value-destroying activities which enhance their personal benefits. Using a sample of U.S. public listed firms that cover fiscal years 2004 to 2011(inclusive of both years), this study provides new evidence suggesting that the effectiveness of CEO pay-performance relationship is weaker for low growth/high FCF firms. Moreover, as expected, this association is significantly positive for high growth firms. Further, this study integrates agency theory with upper echelon and tone at the top theories, and presents a framework that highlights the effects of CEO characteristics on the association between FCF and CEO pay-performance relationship. Consistent with the managerial power theory, this study finds that the association between FCF and CEO pay-performance is relatively weaker for firms with (i) younger CEOs, (ii) longer-tenured CEOs and (iii) firms with CEO duality. This study highlights that some agents have the ability and power to extract higher rents for themselves through the misappropriation of excess funds in firms with severe agency problems.