The Endogeneity of Managerial Compensation in Firm Valuation: A Solution

Much of the empirical literature that has examined the functional relationship between firm value and managerial ownership levels assumes that managerial ownership levels are exogenous and are the only component of managerial compensation related to firm performance. This assumption is contrary to the theoretical and empirical literature wherein managerial compensation is endogenously determined and includes both shares and options. Using instruments for managerial compensation and panel data to control for unobservable heterogeneity in the firm’s contracting environment, we estimate a system of simultaneous equations. We find that firms are in equilibrium when they endogenously set their chief executive officer’s compensation.