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This study investigates whether the variation in executive compensation play an important role in allocation of internal generated cash flow. Several financial literature focus on the issue of cash-flow sensitivity on various uses of internally generated cash flow. Firms are able to distribute their incremental cash flow to payout dividends, reimburse debt, raise equity, hold cash as precautionary savings or increase the investment to obtain the growth opportunity in the future. However, a few studies investigate the change in cash-flow sensitivity on various uses after incorporating the variation in executive compensations and other control variables. According to academic theory of incentive-pay and agency problems, CEOs have incentive to allocate more cash flow to risky investment projects in order to increase their contingent rewards if there is more free cash flow in a firm. Accordingly, we propose that cash-flow sensitivity on investment and cash holding are more volatile than other uses in firms when we take account of variation in different types of executive compensation. This proposition highlight an interesting phenomenon that overinvestment directly connects to overpayment of CEOs. Moreover, we clarify that restriction on executive compensation, perhaps reduces the agency cost but it also forces firms to reduce managerial talent or effort such that cash-flow sensitivity of various uses would rely on the type of executive compensation. Using the cash-flow sensitivity model, we find that the variation in executive compensation would change the allocation of cash flow and lead to agency problems. After controlling the firm’s characteristics, CEO’s characteristics and governance characteristics, we highlight that time varying excess executive compensation significantly explain the cash-flow sensitivity on various uses. In particular, the performance-sensitive pay (incentive-pay) induced by self-serving motivation and unobserved CEO talent is responsible for variation in cash-flow sensitivity on internal cash flow allocation.

Variation in Executive Compensation and Allocation of Cash Flow