Executive risk incentives, product market competition, and R&D

• DOI: http://doi.org/10.1111/fire.12246
• Date: 01 February 2021
• Published date: 01 February 2021
• Author: Hussein Abdoh,Yu Liu

DOI: 10.1111/fire.12246

ORIGINAL ARTICLE

Executive risk incentives, product market

competition, and R&D

Hussein Abdoh1Yu Li u2

1Department of Accounting and Finance,

United ArabEmirates University, Abu Dhabi,

Al Ain, UAE

2Department of Economics and Finance,

University of TexasRio Grande Valley,

Edinburg, Texas,United States

Correspondence

YuLiu, Department of Economics and Finance,

Universityof TexasRio Grande Valley,Edin-

burg,Texas,United States.

Email:yuliucatherine@gmail.com

Abstract

Prior studies have examined the relation between product

market competition (PMC) and research and development

(R&D) investments, while the impact of executiverisk incen-

tives on this relation remains unexplored. In this study, we

find that Vega (the sensitivity of executives’wealth to stock

return volatility) weakens the negative relation between

PMC and R&D. Wealso find that Vega strengthens the nega-

tive relation between PMC and firm performance when R&D

investments grow higher. In sum, our results suggest that

high-Vega compensation portfolios in competitive environ-

ments may induce executivesto overinvest in R&D projects,

therefore hurting firm performance.

KEYWORDS

executive risk incentives, firm performance, investment efficiency,

product market competition, R&D

JEL CLASSIFICATION

D40, G30, G31, J33, M12, O32

1INTRODUCTION

Research and development (R&D) is generally associated with an enhanced competitive position and a better firm

performance. However,executives constantly underinvest in R&D projects, especially in a highly competitive environ-

ment (Gu, 2016). To correct the R&D underinvestmentissue, firms choose to include risk incentives, such as stock

options, in executive compensation packages to encouragerisk taking (Brown & Krull, 2008; Chen, Steiner, & White,

2006; Ryan & Wiggins, 2002;Wu&Tu,2007). What is left unaddressed in the literature is whether executive risk

incentives affect the negative relationbetween product market competition (PMC) and R&D. This study examines the

moderating effect of executiverisk incentives on the PMC–R&D relation, and the moderating effect of executive risk

incentives on the PMC–firm performance relation, following an increase in R&D.

Financial Review. 2021;56:133–156. wileyonlinelibrary.com/journal/fire ©2020 The Eastern Finance Association 133

134 ABDOH ANDLIU

Prior studies (e.g., Guay, 1999; Knopf, Nam, & Thornton, 2002; Smith & Stulz, 1985) have proposed that stock

options, which increase the extent of executives’wealth sensitivity to stock return volatility (Vega), may reduce exec-

utive risk aversionby encouraging risk-taking behaviors. This role of Vega becomes highly relevant for R&D-intensive

firms in a competitive environment. Firm values are more sensitive to the systematic risk associated with cash flows

from R&D when competition from rivals is high. Gu (2016) models PMC as an obsolescence ratethat increases the like-

lihood that potential cash flows from R&D become zero, thereby increasing systematic risk and required return. We

hence examine whether Vegasignificantly affects the level of R&D investments in competitive markets. Several stud-

ies (e.g., Shen & Zhang, 2013) further document that Vega mayinduce executives to make risky investments without

adequately considering profitability.We therefore investigate whether the interaction between Vegaand PMC affects

the performance of R&D investment. Assuming that Vegainduces executives to increase risk taking—recall that R&D

is riskier in competitive industries—executives may makesuboptimal R&D investments in competitive industries to

increase the value of Vega. When suboptimal investment decisions negatively affect firm performance, especially if

the firm operates in a competitive environment, we mayfind that the interaction between Vega and PMC raises R&D

investment but reduces its efficiency.

We focus on R&D for several reasons. First, R&D has unique characteristics that make it different from regular

investments, such as capital expenditures.Shareholders may not be able to evaluate the profitability and characteris-

tics of R&D projects in a timely manner; thus, R&D projects are largely determined by managerial discretion.1There-

fore, examining R&D investment provides an opportunity to detect the impact of executivecompensation on invest-

ments. Second, the economy has always been drivenby knowledge, which, in turn, leads to innovation and technology

improvement. Hence, R&D is probably the most important corporate investment whose efficiency influences firms’

future performance. Third, some studies have examined the impact of PMC on R&D investment (e.g., Cabral,2000;

Henriques, 1990; Kamien & Zang, 1993;Martin,1996). Extending this line of literature by investigatingthe influence

of executivecompensation on the PMC–R&D relation should be interesting.

This study adds to the literature in two ways. First, previous research on executivecompensation has uncovered

two relations: the executivecompensation–R&D relation (see Shen & Zhang, 2013) and the PMC–compensation rela-

tion (see Cuñat & Guadalupe, 2005). However,we still lack a thorough understanding of the connection between these

two strands of literature. In other words, we do not know the role of Vegacompensation on R&D investment in com-

petitive industries. The extant literatureidentifies competition as a substitute for governance mechanisms (e.g., Allen

& Gale, 2000; Cremers, Nair, & Peyer, 2008). We add to the previous studies by examining how executivecompensa-

tion as internal corporate governance interacts with competition as externalcorporate governance on R&D and firm

value.2The overall evidence supports the substitution argument that competition does not add value when there is

good corporate governance (i.e., risk-taking compensation) in place.3Specifically,competition does not add value to

corporate governance(i.e., corporate R&D investments) with risk-taking compensation. We show a negative impact of

competition on R&D efficiency when executiveshave higher risk-taking incentives.

Second, this study relates to the literature pertaining to the dark side of executivecompensation that encourages

risk-taking. In prior literature,Armstrong, Larcker, Ormazabal, and Taylor(2013) find evidence that Vega has an unam-

biguously positive incentive effect on misreporting. Peng and Roell (2008) also show managerial compensation may

lead to price manipulation. In our study,we find that an excessive adoption of incentive schemes in competitive indus-

tries has another unintended consequence—inefficient R&D investments—which maylead to low firm performance.

The findings herein carry useful implications for executive compensation programs. Prior studies (e.g.,Agrawal &

Mandelker,1987; DeFusco, Johnson, & Zorn, 1990;Guay,1999; Rajgopal & Shevlin,2002; Tufano, 1996) prove that

1Theterms exe cutive and managerial are used interchangeably.

2Nguyen(2018) examines the relation between chief executive officer (CEO) incentives and corporate innovation, as well as how this relation is affected by

differentmarket environments. Our study focuses more on the moderation effect of executive risk incentives on the PMC–R&D relation, and the moderation

effectof executive risk incentives on the PMC–firm performance relation when firms activelyengage in R&D. The dependent variables, independent variables,

andregression methods are also different between the two studies.

3Giroudand Mueller (2011) find that firms in competitive industries benefit less from good governance.