Executive salaries have been shown to be more closely correlated to the size of
ID: 2709990 • Letter: E
Question
Executive salaries have been shown to be more closely correlated to the size of the firm than to its profitability. If a firm’s board of directors is controlled by management rather than outside directors, this might result in the firm’s retaining more earnings than can be justified from the stockholders’ point of view. Discuss those statements, being sure (1) to discuss the interrelationships among cost of capital, investment opportunities, and new investment
and (2) to explain the implied relationship between dividend policy and stock prices.
Explanation / Answer
In modern corporate trend, executives are less constrained to achieve company's economic goals, since the firm is not controlled by ownership. Therefore, interests of executive encourage to increase size of the firm rather than profitability of the firm. Therefore, when the size of the firm is larger, marginal productivity of the firm becomes higher.
1) Due to higher productivity investment opportunities increases. This helps in introducing new investments. This also affects cost of capital positively.
2) Due to higher marginal productivity and firm's growth, firm introduces dividend policy. This demonstrate firm's ability to retain earnings to exploit new growth opportunities. Due to which stock prices also increase to have more investment in the firm.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.