‘The rapid rise in CEO pay over the past 30 years has sparked an intense
debate about the nature of the pay-setting process. Many view the high level
of CEO compensation as the result of powerful managers setting their own pay.
Others interpret high pay as the result of optimal contracting in a competitive
market for managerial talent…..”

Carola Frydman and Dirk Jenter NBER Working Paper No. 16585 Decem
ber 2010

This issue has been well researched and the question is whether the CEO
compensation is driven by the CEO charactersitics or the firm performance or
both. Use classical linear regression model to examine this issue and explain
your findings. Not required but you can add an intro paragraph to the problem.

Consider the CEO salary equation to be estimated as the following base
equation:

log(salary) = β0 + β1log(sales) + beta2log(mktval) + u

1. Compare this log constant elasticity model with lin-lin model .

1. What do you find about how company sales and market value effect CEO
salary. Interpret your findings and do relevant hypothesis tests.

a. Estimate a model relating annual salary to firm sales and market value.

Make the model of the constant elasticity variety for both independent vari
ables. Write the results out in equation form. Find the sample correlation
coefficient between the variables log(mktval) and profits. Are these variables
highly correlated? What does this say about the OLS estimators?

b. Add profits to the model from part (1). Why can this variable not
be included in logarithmic form? Would you say that these firm performance
variables explain most of the variation in CEO salaries?

2. Does CEO demographic and human factors have any effect on their
salary?

a. Look at this in 2 seperate models, CEO characteristics only and then in
the second model together with the firms characteristics.

b. Add the variable ceoten to the model in part (1). What is the estimated
percentage return for another year of CEO tenure, holding other factors fixed?

c. Are there any significant non-linearities in CEO tenure (estimate and
conduct relevant hypothesis testing).

d. In your model with both firm and CEO characteristics: after controlling
for company fundamentals does years with the company (comten) and years as
CEO (ceoten) are jointly significant?

e. (i) Does grad school significantly increase CEO earnings? (ii) Do grad
CEOs earn more than the college CEO’s? (Interpret the findings and conduct
relevant hypothesis testing).

f. Does the effect of market value of the firm (mktval) have a differential
effect on the CEO salary if the CEO has attended graduate school?

3. From the model from (2) generate estimated residuals and check if there
is heteroscedasticity? Report heteroscedasticity corrected standard errors.

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