The be looked into and is of concern, apart

The companies which adopted this
EVA-based performance evaluation and compensation system comprised the ‘Treated
Group’. The companies which did not use this system comprised the ‘Non-Treated
Group’. The term ‘counterfactual or unobservables’ here means the factors
affecting both the treatment selection and the treatment outcome i.e., if
managers or the firms had some kind private or insider information which was
not available to or observable by any of the other market participants, which
led them to adopt (treatment selection) the EVA-based performance evaluation
and compensation system in their firms, and that in turn affected their firms’
performance (treatment outcome), is something which is needed to be looked into
and is of concern, apart from what is already conspicuous and observable. The
counterfactual here is the ‘outcome of the choice not made’ i.e., the outcome
in terms of firms’ performance, if the managers had not made a choice to adopt
EVA-based performance evaluation and compensation system for the same firm. If
a counterfactual or an unobservable affects either the treatment selection or the
treatment outcome but not both, it may not necessarily cause any estimation
bias.

 

The self-selection bias that gets
introduced, if firms self-select themselves as EVA-based Compensation adopters
or non-adopters, on the basis of having adopted EVA-linked performance
evaluation and compensation system criterion, needs to be corrected to get rid
of this endogeneity. Heckman’s Inverse Mills Ratio Method, Heckman’s Two-Stage
Correction Model or Heckit Probit Correction Model, as it is sometimes called,
is hence used to address this the self-selection bias in the sample due to
counterfactuals is being corrected using the two-stage regression as was
suggested by Heckman in late 1970s (Heckman, 1977). This is to say that, the companies which expect a
positive EVA would tend to link EVA to Compensation and the management’s
perspective that linking EVA to Compensation would lead to better firm
performance is tested using Inverse Mills Ratio. Using the Heckman Model, if an
insignificant Inverse Mills Ratio is obtained, it can be interpreted that the
companies were correct in their decision of linking EVA to Compensation
provided their EVA was positive and that there was no self-selection bias.
However, if the Inverse Mills Ratio is found to be significant it would mean
that these companies have vested interest in linking EVA to Compensation, as
their firm’s had positive EVAs.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

 

 

In this paper we  used pooled data of 500 Indian firms for the
period of 11 years from 2005 to 2015 and study the performance of the firms in
India that have adopted EVA-based compensation system to see if such
compensation structures have affected their future performance. Since the
sample of firms opting to use the EVA-based compensation systems is likely to
suffer from the self-selection bias, we use Heckman’s Two-Step Correction Model
to adjust for possible endogeneity. Since the
sample of firms opting to use the EVA-based compensation systems is likely
suffer from self-selection bias, we plan to use Heckman’s (1977) two-stage
regression to adjust the bias because the managers of the
Indian firms may or may not have made a conscious choice of using an EVA-based
performance evaluation and compensation system in their self-interest. We made sure that to address the
self-selection bias present in the firm’s choice of having an EVA-based
performance evaluation and compensation system as a part of their governance
and the consequent endogeneity issues that affect the regression results. We look at the financial performance of firms that have
adopted EVA-based compensation system in India, for the period 2005-2015. We
obtain the enterprise value by adding the present value of EVAs to the book
value of operating capital. So any attempt to increase the EVA in one year
(keeping the EVAs of other years constant) will lead to an increase in stock
price.

 

2. Background

Ample research exists on how
appropriate compensation system for the top executives can be developed to
align the interests of the management and the shareholders (Kerr and Bettis,
1987; Kosnik and Bettenhausen, 1992; Mehran, 1995; Kole, 1997; Cyert, Kang,
Kumar, 2002). Starting with the seminal works on agency theory by Jensen and
Meckling (1976), and Fama (1980), finance theory boasts of excellent research
done in the field of determinants of agency costs, and steps the firms can take
to reduce such agency costs (Pogano and Roell, 1998; Ang and Cole, 2000;
Fleming, Heaney and McKosker, 2005; McKnight and Weir, 2009). There is no
consensus, however, on whether the performance based incentive plans help
mitigate the agency costs or accentuate them. In this paper, we study the
performance of the firms in India that have adopted Economic Value Added (EVA)
based compensation system to see if such compensation structures affect the
future performance of the firms.

 

The seminal work on agency theory
by Jensen and Meckling (1976) and Fama (1980) has also encouraged financial
economists to do further research on agency costs, its determinants and
possible ways to alleviate them (Jensen, 1986; Ang, Cole and Lin, 2000; Jensen,
2005; Dalton, Hitt, Certo, 2007). Fama (1980) suggested use of appropriate
incentive system for aligning the interests of the management and shareholders
to mitigate this agency costs.

 

Principal-agent theory predicts that a
firm designs compensation contracts in order to yield optimal incentives,
therefore motivating the CEOs and Top Managers to maximize shareholders’ value1 The
classic principal-agent model acknowledges that the noise of a given
performance measure determines its suitability for use in compensation
contracts. In designing the contract, the firm makes sure that it reduces
manager opportunism and motivates executives’ effort by providing incentives
through risky compensation. The optimal contract does not imply a ‘perfect’
contract, but only that the firm designs the best contract it can in order to
avoid opportunism and malfeasance by the manager. Often, these executives are
rewarded for an above average performance only, however, they are not punished
for a below average performance. Also, there are many CEOs who receive high pay
but their companies fail to deliver even a below average performance. These
executives receive incentives from several sources. They receive these
financial incentives in the form of, not only salaries and bonuses, but also,
new grants of stock options or restricted stock and while it is clear that, it
is common to have a mix and match of all the aforementioned components in the
executive compensation package, the variable pay plans, especially the
performance-based ones have been receiving more attention in recent years.

 

Sir I
need a connecting sentence here to connect with the following section.

1 www.lse.ac.uk/fmg/researchProgrammes/…/executiveCompensationAndIncentives.pdf