A STUDY OF THE RELATIONSHIP BETWEEN CEO COMPENSATION AND FIRM PERFORMANCE IN THE US AIRLINE INDUSTRY 2002 2006

job performance

A STUDY OF THE RELATIONSHIP BETWEEN CEO COMPENSATIONAND FIRM PERFORMANCE IN THE U.S AIRLINE INDUSTRY: 2002-2006

ByTrudy Dawkins Morlino

RICHARD MURPHY, D.B.A., Faculty Mentor and Chair

THOMAS FORD, Ed.D., Committee MemberKENNETH GRANBERRY, D.I.B.A., Committee Member

Kurt Linberg, Ph.D., Dean, School of Business & Technology

A Dissertation Presented in Partial Fulfillment

Of the Requirements for the DegreeDoctor of Philosophy

Capella University

September 2008

3324731

3324731 2008

Copyright 2008 by

All rights reserved

© Trudy Morlino, 2008

AbstractThis study addressed the relationship between CEO compensation and firm performance in the U.S domestic passenger airline industry, a low managerial

discretion industry To answer the question, is there a relationship between CEO

compensation (salary plus bonus) and the independent variables, return on assets, return

on equity and the debt-to-asset ratio, this study applied nonparametric statistics to a sample of publicly traded U.S airlines for a five-year period, 2002-2006 Data for the study period relied exclusively on secondary data compiled by the Securities and

Exchange EDGAR database and publicly available annual reports The sample for this study consisted of 15 years of CEO compensation and firm performance data for three

of the historically dominant U.S scheduled domestic passenger airlines, SIC 4512, NAICS 48111 This study was limited to publicly traded U.S ‘legacy’ airlines that operated primarily as a scheduled air passenger service where the CEO of the firm held the position for three consecutive years during the study period Tests were conducted using Pearson product moment correlation and Spearman’s rank correlation However, for this study, all hypotheses were tested using Spearman’s correlation coefficient

Spearman’s rho (p) nonparametric statistic was chosen because three major assumptions

of the Pearson’s parametric correlation (r) were violated The results indicated that

there is a statistically significant negative relationship between the rank ordered CEO compensation (salary plus bonus) and rank ordered return on assets (ROA) The study found no statistically significant relationship between rank ordered CEO compensation (salary plus bonus) and rank ordered return on equity (ROE) or between the rank

ordered CEO compensation (salary plus bonus) and the rank ordered debt-to-asset ratio

This work is dedicated to my daughter, Rebecca, who gave me the courage to undertake this project Without her love, understanding and support this work would not have been possible Her encouragement, patience, and belief in me throughout this journey allowed me to reach my goal

I would also like to dedicate this work to my husband, Buster, my sister, Cassie, and my brother, Chuck, for their ability to offer constructive criticism when needed as well as for their financial support throughout this process

To my parents, Becky and Harold Dawkins, who are looking down on me from above, thank you for giving me the foundation I needed to even consider such an undertaking as this

First and foremost, I am extremely grateful to my mentor, Dr Richard Murphy, for his support and guidance He managed to keep me focused and helped me to see the light at the end of this very, long tunnel Without his advice, wisdom, and humor, this project would have never been completed The insightful suggestions from my

committee members, Dr Kenneth Granberry and Dr Tomas Ford, helped to shape the final product

I am also grateful to Steve Creech who helped me with the statistical tests and analysis His knowledge and support guided me through many storms

Finally, a debt of gratitude goes to my colleagues who laughed with me and cried with me throughout this journey, thank you!

Is There a Diminishing Marginal Utility to Money? 53

CHAPTER 5 DISCUSSION, IMPLICATIONS, AND RECOMMENDATIONS 100

Introduction 100

List of Tables

Table 1 Revenue Passenger Miles (RPM) and Market Share Percentage 17Table 2 CEO Compensation Factors and Correlated Studies 55

Table 4 Spearman’s rho for Rank Ordered Study Variables With Outliers 77Table 5 Descriptive Statistics for Study Airlines 78Table 6 Rank Ordered CEO Compensation and Rank Ordered Return on

Table 7 Rank Ordered CEO Compensation and Rank Ordered Return on

Table 8 Rank Ordered CEO Compensation and Rank Ordered Return on

Table 9 Rank Ordered CEO Compensation and Rank Ordered

Table 12 Summary of Research on CEO Compensation, ROA, and ROE 98

List of Figures

Figure 3 Scatter plot of CEO compensation and return on assets (ROA) 81Figure 4 Scatter plot of rank ordered CEO compensation and rank ordered

Figure 5 Scatter plot of rank ordered CEO compensation and rank ordered

Figure 6 Scatter plot of rank ordered CEO compensation and rank ordered

Figure 8 Scatter plot of CEO compensation and return on equity (ROE) 88Figure 9 Scatter plot of rank ordered CEO compensation and rank ordered

Figure 12 Rank ordered CEO compensation and rank ordered

CHAPTER 1 INTRODUCTION TO THE STUDY

Introduction

It is generally accepted that the role of the chief executive officer (CEO) has the greatest influence on the performance of the firm and is considered by many as the most important role in the management of a corporation In publicly traded U.S

corporations, the CEO’s primary responsibility is to carry out the strategic plans and policies established by the board of directors As the leader of the firm, the CEO has an astounding impact on the performance of the firm and many believe this to be the result

of the tremendous growth in executive compensation over the last several decades Others have suggested that the growth in executive compensation is not related to firm performance For instance, Abowd and Kaplan (1999) argue that firm size may be the reason for the variability in CEO compensation while firm profitability appears to be an insignificant factor in executive compensation Conversely, Deckop (1988) found that CEO compensation was positively correlated to firm profit as a percentage of sales Labor market theory posits that the demand for highly skilled and well-educated

workers remains relatively scarce in the market thus; the rising demand for the skills of

a CEO has shown up in rapidly rising compensation for CEOs (McConnell & Brue, 2005)

In the last several decades, CEO compensation has become a major controversy among shareholders, in the media and academia, and has experienced pressure in the legislature and economic arenas The literature suggests there are many and varied reasons for the interest in executive compensation in U.S corporations However, one indicator appears to be the most prevalent In 2005, the average CEO in the United States earned more in one workday than the average worker earned the entire year

(Mishel, 2006) This provokes criticism from many regardless of how efficient the firm Furthermore, high profile corporate scandals which brought about a new set of rules for governance in all aspects of business caused increasing attention to executive

compensation and firm performance Over the last several years, an unprecedented number of cases of corporate corruption have been revealed More than 700 U.S companies were forced to correct misleading financial statements as the result of

accounting failures and fraud which was discovered in the 1990s (Smith, 2002) Since

2000, several hundred companies have been forced to correct misleading reports for the same reasons Enron, considered one of the largest corporate scandals in U.S history, reportedly cost investors an estimated $100 billion (Patsuris, 2002) The Enron case challenges the core beliefs and practices of corporate managers and the governance of corporations in the United States and legislators and regulators have been quick to respond to the latest corporate scandals

Despite the debate among the academic and business presses, political parties and government, there still remains no clear picture about the determinants of CEO compensation including the measurement of the various variables involved in the

calculation of CEO pay Moreover, there remains no clear picture of how to measure firm performance in relation to the compensation received by the CEO of publicly traded airlines in the United States

History of the U.S Airline IndustryThe aviation industry began in 1903 with the first successful flight by the Wright brothers in Kitty Hawk, North Carolina However, the demand for air travel did not take hold until 1927 when Charles Lindbergh made the first successful overseas flight

By 1938, passenger air travel was increasing and the competitive nature of the industry called for restructuring The Civil Aeronautics Act of 1938 created a new commission

to regulate passenger air fares and air mail routes, to monitor acquisitions and mergers, and to distribute air routes to airline carriers Amid increasing concerns about air travel, Congress passed the Federal Aviation Act of 1958 that created the Federal Aviation Agency (FAA) which was responsible for developing an air traffic control system In

1967, the Federal Aviation Agency was renamed the Federal Aviation Administration and placed under the control of the U.S Department of Transportation (DOT)

Beginning in the 1970s, the inefficiency of the government regulated airline industry became of paramount importance to those in the industry and the U.S economy as a whole Greenslet (1998) argues that the U.S Congress passed the Deregulation Act of

1978 as one way to slow down the rapidly rising air fares in the regulated airline

industry According to Greenslet, this legislation has become one of the most important events in the history of the airline industry because for the first time the industry was allowed to “operate as a true business” (p 6) and air traffic grew by a factor of three as the price to the consumer of air travel declined

In a hearing before the subcommittee on aviation (2005), John Mica (R-FL), committee chairman, stated that “historically, airlines have failed at a much higher rate than most other types of businesses [and] the industry has the worst financial

performance of any … major business sector” (p 2) Although the industry has seen some profitable years, the industry as a whole has lost money since deregulation Kiefer (2005) reported during the same hearing that as of 2005, the U.S commercial airline industry was suffering from the “greatest crisis in its nearly 100 year history” (p 51)

He further stated that shareholders had lost over $24 billion in market value and since

2000 half of the largest airlines in the U.S have entered Chapter 11 bankruptcy To cut costs, the airlines renegotiated pay and benefits for employees including pension plans which resulted in substantial decreases to most airline employees United and US Airways failed to meet their financial obligations on their pension plans which resulted

in the largest pension default in U.S history

Industry StructureIndustrial organization economics provides the underlying theory of how firms are organized and how they compete (Carlton & Perloff, 2000) Industry structure drives competitive behavior and determines industry profitability (Grant, 2005) The market structure of the airline industry is characterized as an oligopoly (Bailey, 2002), a form of imperfect competition in which there is a small number of relatively large competitors selling a standardized or slightly differentiated product and each seller has substantial market control The industry concentration ratio is a standard measure of oligopoly market power This ratio indicates the market share of the largest firms in the industry to the size of the entire market (Rubin & Joy, 2005) From 2002-2006, three major U.S airlines had approximately 52 percent market share of passengers

One major characteristic of an oligopoly is high capital investment which results

in high fixed costs Fixed costs in the airline industry are generally composed of flying operations, aircraft and traffic service, maintenance, general and administrative costs, and depreciation (Air Transport Association) Moreover, since deregulation in 1978, there exist few barriers to entry in the airline market as evidenced by the number of air passenger carriers who have entered and exited the market Allowing new carriers to enter and exit the market has placed a substantial burden on the major carriers as

consumers of air travel now have the ability to substitute low cost airlines Legislation

as well as technological advances has reshaped the demand for air travel allowing consumers of air travel unprecedented price transparency

The demand for air travel is highly cyclical and the structure of the industry causes instability Hecker (2005) argues that the inherent instability of the airline industry can be traced to the structure of the industry and its economics, including the highly cyclical demand for air travel, high fixed costs, and few barriers to entry The business or time-sensitive air traveler has historically been a major source of profit for the airline industry A key assumption in the airline industry has been that the time sensitive passenger or business traveler was price inelastic with respect to air fare That

is, a business air passenger would pay a high fare as long as the service was reliable and flexible However, the airline industry has realized that a large proportion of air

passengers are price sensitive and many will choose a low fare price over service and flexibility thus, the demand of air travel has become more elastic with respect to price The entry of low cost airlines which is a close substitute for the major airlines and corporations who wish to decrease travel costs, have led to a decline in business travel for the major airline carriers

According to Mann (2003), an airline industry consultant, it has always been presumed that demand for business air travel is price inelastic However, he concluded that with the entry of low cost carriers such as Southwest Airlines, corporate fliers may become more price elastic Several major carriers tested the theory of price elasticity for the business traveler by reducing fares on a few of their routes For example, United Airlines reduced by as much as 40% the price charged for last-minute travel on direct flights between two major cities United Airlines also reduced by approximately 70%

the fare on tickets with a seven day advance purchase Harrell (2003) reported that these fare reductions were aimed specifically at the corporate traveler because it is these travelers who are not flying as much as they have in previous years Belobaba (2005) asserts that since September 11, 2001, “business travelers are no longer willing to pay 5

to 8 times the lowest available rate” (p 14)

In his testimony before the Subcommittee on Aviation, Costello (2005) argued that the U.S commercial airline industry was “in trouble” (p 3) prior to the terrorist attacks on September 11 because “legacy” carriers “failed to adjust their business models that depended on extracting a premium fare from business traveler” (p 3) He further stated that “the premium fare for business travelers amounted to a significant amount of revenue for the legacy carriers” (p 3) thus the business traveler is more price sensitive than assumed as they have chosen to fly on low cost airlines rather than legacy airlines Brown (2007) concurred that the airline industry recognized that the leisure traveler is price inelastic with respect to air travel whereas the business traveler has historically been price elastic with respect to air travel

Bhadra (2003) suggests that the demand for air travel is represented by revenue passenger mile (RPM) and is a function of income as represented by GDP He

estimated the elasticities of demand for U.S domestic air markets between 0.55 and 1.8 Greater price transparency and increased competition increases consumer price

elasticity For example, leisure travelers, which comprise approximately 85 percent of all airline tickets sold (Tully, 2001), have a relatively high price elasticity of demand of approximately 2.4 (Anderson, McLellan, Overton, & Wolfram, 1997) indicating that a

10 percent decrease in air fare results in a 24 percent increase in sales

Several significant factors have contributed to the dramatic changes in the U.S airline industry Intense price competition in the domestic market as a result of

deregulation, the Gulf War in 1991, the SARS epidemic in 1993, the terrorist attacks on September 11, 2001, the ongoing wars in Afghanistan and Iraq, extremely high jet fuel prices, heavy debt and pension burdens, and labor costs which are the single largest category of airline costs, have all changed the competitive environment of the industry The airline industry is very labor intensive Coupled with strong airline labor unions, airline industry employees have significant bargaining power and the industry has historically been susceptible to labor strikes which cause a significant loss of revenue to the airline Some might suggest the airline problems are directly related to the bad habits and customs that were developed when they did not have to be concerned about being competitive

This study seeks to add to the existing body of literature in the area of executive compensation and firm performance by examining the relationship between CEO

compensation and firm performance in a sample of firms in the U.S scheduled

passenger airline industry from 2002-2006 This time period was chosen because it falls within five years of the terrorist attacks on September 11, 2001 and as such the airline industry has undergone dramatic changes

Background of the StudyCrumley (2006) argues that although there have been hundreds of studies

conducted on executive compensation and firm performance but limited progress has been made using economic arguments Research suggests that agency theory, human capital theory, contract theory, marginal productivity theory, labor theory, and others

have attempted to explain the relationship between CEO compensation and firm

managerial discretion Industries that fell between 4 and 5 on the scale would have medium managerial discretion, and those that fell between 6 and 7 on the scale would have high managerial discretion However, the extant literature appears to be

inefficient in explaining the relationship between CEO compensation and firm

performance in the U.S scheduled passenger airline industry

The business press reports that in the airline industry, CEO compensation does not appear to be connected to firm performance One often cited example comes from

U.S News and World Report (1992) who reported that in 1990, the head of United

Airlines, Stephen Wolf, received more than $18 million in compensation while United’s corporate profits plunged 71 percent More recently, in 2006, United Airlines emerged from bankruptcy and CEO, Glenn Tilton, received a compensation package valued at

$39.7 million (Kukec, 2007; Friend, 2007) When Northwest Airlines emerged from

bankruptcy protection in 2006, The Wall Street Journal (Carey, 2007) reported that

CEO, Doug Steenland, received $26.6 million in restricted stock and options and four vice presidents received equity grants valued from $10 million to $13.5 million In a

separate report, The Wall Street Journal noted that airlines are a high-profile incubator

of broader trends in business and as one airline pilot noted:

When will the legalized looting of companies stop in this country?

Bonuses for AMR [American Airlines] execs based on stock price only? No consideration for company performance? Eight percent of stock to UAL [United Airlines] execs? Employees that have 20% to 60% pay cuts, lost pensions, benefits, etc.? Let’s call it what it is: A financial raping of employees

(McCartney, 2006, ¶14)

Since 2001, all but one of the major airlines has filed for Chapter 11 bankruptcy

protection For example, US Airways filed for protection in August 2002, United filed

in December 2002, and Northwest and Delta field in September 2005 According to ATA Vice President and Chief Economist, John Heimlich, U.S passenger and cargo airlines recorded a $2.5 billion net profit in 2000 but between 2001 and 2005, the industry had cumulative net losses of $35 billion (Heimlich, 2007) Michael Boyd, an airline industry consultant, noted that although none of the major airlines have gone out

of business since 2001, restructuring of the major airlines through Chapter 11

bankruptcy was equivalent to losing one major U.S airline (Isidore, 2005)

Historically, the CEO has the greatest influence on firm performance and is usually regarded as the most powerful member of an organization (Hambrick & Mason, 1984; Daily & Johnson, 1997) A report issued by Booz Allen Hamilton, an

international management consulting firm, reported that to many employees, CEOs are

the “emperors of global business” (Lucier, Spiegel, & Schuyt, 2002, 1) Shore (2003) reported that corporate executives

are a bit like medieval knights granted great tracts of land by grateful monarchs

It was always too much to expect them to say, “Thank you, milud, but the little cottage by the main gate will do me nicely.” Or, indeed, at some later date suggest: “Since I lost that battle, here’s half my land back.”(¶4)

Statement of the Problem The main objective of this study is to investigate the relationship between CEO compensation and firm performance from a sample of publicly traded firms in the U.S domestic scheduled passenger airline industry as it relates to managerial discretionary decision making for the years 2002-2006 CEO compensation has been the focus of many studies in academia, widely discussed in the media, and the topic of conversation among stockholders, stakeholders, and the public at large In 2005, half of all U.S households owned stocks either directly or through mutual funds leading to an increased awareness of the relationship between CEO compensation and firm performance

Revell (2003) reported that although Delta Airlines lost $1.3 billion and its stock price decreased by 58 percent, the CEO received $1.4 million in bonus pay, $2 million in stock, and $4.5 million in the CEOs pension fund Furthermore, Delta

Airlines also awarded its CEO $3.7 million to cover the cost of his tax payments to the Internal Revenue Service (IRS) Some studies have indicated that large executive salaries are correlated to the executive’s age, education, tenure with the firm, experience

in the industry, size of the firm, and various other factors Three months prior to

declaring Chapter 11 bankruptcy, the CEO for United Airlines received $4.5 million in

his pension trust Six months prior to declaring Chapter 11 bankruptcy a top executive with US Airways received a $15 million lump sum payment from his pension plan which “included 24 years of service [he] never worked” (Revell, 2003, 68)

The Campbell-Hill Aviation Group (2006), an aviation and economic research consulting firm, reported that in 2004, the U S commercial aviation sector accounted for $1.2 trillion in output, supported 11.4 million jobs, and contributed $380 billion in personal earnings The airline industry is a dominant factor in the U.S economy as measured by gross domestic product (GDP) and historically, the demand for air travel grows two times as fast as GDP (Love, Goth, Budde, Schilling & Woffenden, 2006) The U.S airline industry is highly dependent on the health of the U.S economy

However, the significance of CEO compensation and firm performance in the U.S airline industry has not been fully researched Moreover, there have been no attempts to study the airline industry in relation to the levels of discretion as established by

Hambrick and Abrahamson (1995)

Shareholder wealth maximization is considered by many to be the primary objective of any corporation According to the Investment Company Institute, in 2005, approximately half of all households in the U.S owned stocks directly or through

mutual funds Millions of consumers own an interest in U.S corporations in the hope that an investment will lead to personal wealth creation Executives of firms operating

in competitive markets, such as the airline industry, are more likely to maximize stock price if they are themselves shareholders of the firms’ stock (Brigham & Houston, 2004) However, in many large corporations, executives own only a small percentage of the stock which could lead to conflicting goals between management and shareholders with shareholder wealth maximization becoming less important Some have argued that

an agency problem arises when management’s goal is to increase firm size rather than maximize shareholder wealth Moreover, it has been suggested that increasing firm size leads to executive job security and increases personal power, status, and salary

Frydman and Saks (2007) argue that competition for scarce managerial talent may lead

to high executive compensation in large firms

Agency theory predicts that there is a conflict of interest between the CEO and the shareholders they represent because the CEO will act in his/her own self-interest to pursue goals that maximize their personal welfare (Veliyath & Bishop, 1995) Contract theory predicts that the optimal compensation contract depends on not only firm-

specific factors but also on CEO specific factors (Kim 2004) Weisbach (2006) argues that the optimal contracting approach to executive compensation does not filter out factors that are beyond a managers’ control that may affect firm performance Research suggests that pay-for-performance measures as components of executive compensation are absent from U.S corporate governance strategy leading many to conclude that executive compensation is not linked to firm performance Bebchuk and Fried (2004) suggest that executives who have ‘power’ particularly “vis-à-vis their boards” (p 5) will receive higher compensation regardless of firm performance Agle (1993) asserts that CEO power has the potential to create greater firm performance but for CEOs whose power increases over time, maximizing ones own utility rather than firm performance becomes paramount

Leonard (1990) examined more than 20,000 executives at 439 corporations in the U.S from 1981 through 1985 Not surprisingly, he found that executive

compensation was highly significant to the hierarchical structure of corporation That

is, the executives’ step on the hierarchical ladder was the most significant factor in

determining the level of executive compensation He concluded that firms with a hierarchical structure compensated executives more highly than firms in flat

organizations and greater growth in return on equity (ROE) was associated with

hierarchical firms

Ha (2000) argues that human capital theory explains the link between CEO compensation and firm performance particularly the CEO’s level of education and CEO tenure which he suggests are positively correlated with compensation and firm

performance However, CEO compensation is also affected by other variables such as firm size and tenure with the firm not just tenure as CEO A reasonable level of

executive compensation should include but not be limited to CEO-specific factors such

as the individual’s education, experience, skills, duties, and responsibilities The level

of executive compensation should also consider firm-specific factors such as the

company’s revenue size, compensation philosophy, the industry in which the firm operates, market conditions, and the availability of talent (Dorf, 2006)

Executive compensation has become one of the most public components of the decision-making process of a firm’s board of directors The Corporate Library (2007), considered by many to be an unbiased, independent source for company information including U.S corporate governance and executive compensation, analyzed executive compensation components and suggests that several factors negatively affect the CEO compensation rating assigned by their firm These factors include (a) CEO base salary over $1 million, (b) a CEO bonus greater than twice the annual salary, (c) a declining number of CEO shares held, (d) excessive CEO stock options holdings, and (e) high tax

or leisure expense payments

Media headlines for the last several years indicate that the general public has become outraged over what many consider excessive CEO compensation To cite a few

examples: The Washington Post, “Airline Bonuses Put Executives In the

Hotseat” (Wilber, 2007); Reuters, “US Airline Workers Bristle at Executive Paychecks” (Peterson, 2007); The Wall Street Journal, “Outrage Over Executive Compensation Has Hit a Boiling Point (Lublin, 2007); USA Today, “CEO Pay Soars” (Strauss & Hansen, 2006); Forbes, “Deep Hatred At The Airlines” (Tatge, 2005); Fortune, “Can Even Heroes Get Paid Too Much?” (Stewart, 1998); and Industry Week, “How Much Is Too

Much?” (Mariotti, 1998)

In her report to Congress, Levine (2004) stated that three arguments were

typically made to justify large executive compensation packages; first, the size of the compensation package is proportionate to the responsibilities associated with the

position; second, large compensation packages were necessary to retain executives; and third, the small pool of qualified candidates justifies large compensation packages

Senator Joe Lieberman (then D-CT) urged then Homeland Security Secretary, Tom Ridge, to review the executive compensation packages of all airline executives prior to releasing the $2.3 billion of federal “bailout money” that Congress passed with the Emergency Supplemental Appropriations bill (Lieberman, 2003) The Senator placed particular emphasis on American Airlines executives whom he says “designed extravagant retention bonuses and special funds for themselves” while drastically reducing the pay and benefits of other employees

Collectively, the U.S airline industry had net a loss of $31.5 billion from 2001 through 2005 (J P Heimlich, personal communication, May 8, 2007) John Heimlich, chief economist for the Air Transport Association, reported that prior to the terrorist

attacks of September 11, 2001, six major carriers, American Airlines, Continental, Delta, United, Continental, Northwest, and US Airways, had decreased employment by

38 percent (169,000 full-time jobs) and reduced their fleet size by about 23 percent or more than 800 planes in order to cut costs (Isidore, 2006) However, during the period

1996 through 2000, the airline industry had one of the most prosperous periods in the history of aviation (Tully, 2001) earning $20.5 billion in net profits (J P Heimlich, personal communication, May 8, 2007)

Purpose of the Study The main purpose of this study is to investigate the relationship between CEO compensation and firm performance among publicly traded firms in the U.S domestic scheduled passenger airline industry as it relates to managerial discretionary decision making for the years 2002-2006 This timeframe was chosen to evaluate CEO

compensation and firm performance in the U.S airline industry post-September 11,

2001

CEO compensation in this study will consist of salary plus bonus Firm

performance will be measured by return on assets (ROA), return on equity (ROE), and the debt to asset ratio Comparisons will be made between CEO compensation and firm performance measures Return on assets (ROA) was chosen for this study as an

indicator of firm performance because of its relationship to firm profitability Return on assets (ROA) reveals how much profit a company earns for every dollar of its assets (McClure, 2005) Return on equity (ROE) was chosen for this study as the leading indicator of firm performance because it is commonly considered to be the strongest barometer of how effective a firms’ management uses investor funds According to

Ross, Westerfield, and Jaffe (2008), return on equity (ROE) is the “true bottom-line measure of [firm] performance” (p 53) Although different, ROA and ROE, provide a clear picture of management’s effectiveness Yousef and Mohammed (2006), suggest that in an efficient market, ROA and ROE may be correlated with performance but by utilizing ROA and ROE rather than a single indicator such as stock price, those

circumstances when the market may not be efficient tend to be alleviated The debit-to- asset ratio was considered as a measure of firm performance for this study because it measures the financial strength of the firm In other words, the debt- to- asset ratio reflects the proportion of assets that has been funded by debt and is an indicator of the extent to which the firm is utilizes long term debt

This study addresses the factors that may effect CEO compensation (salary plus bonus) The sampling frame will consist of CEOs in publicly traded corporations within the U.S domestic scheduled passenger airline industry who have held their current position for at least three consecutive years The sample will consist of three major airline corporations as determined by the eliminating factors such as CEO tenure, the company must be a publicly traded U.S corporation, and the company must be listed a major, legacy carrier in the U.S domestic scheduled passenger airline industry

Furthermore, American Airlines, Delta Airlines, and United Airlines collectively held a minimum of 50% market share in the domestic scheduled passenger air traffic industry for each year in the study, 2002-2006 Table 1 shows the market share and revenue passenger mile (RPM) for each airline in the sample Revenue in the commercial aviation industry is brought in by means of passenger traffic and that is measured in revenue passenger miles (RPM) which is equal to one fare-paying passenger transported one mile (ATA, 2008)

Table 1 Revenue Passenger Miles (RPM) and Market Share

American American Delta Delta United United AirlinesAll AirlinesStudy Year

RPM

Millions

$

Market Share %

RPM Millions $

Market Share %

RPM Millions $

Market Share

%

RPM Millions

$

Market Share

compensation and firm performance in a sample of publicly traded firms in the U.S

domestic scheduled passenger airline industry as it relates to managerial discretionary

decision making

The following research questions are proposed for this study

1. Is there a significant relationship between CEO compensation (salary plus bonus) and return on assets (ROA) at the low level of managerial discretion

in the U.S scheduled passenger airline industry?

2. Is there a significant relationship between CEO compensation (salary plus bonus) and return on equity (ROE) at the low level of managerial discretion level in the U.S scheduled passenger airline industry?

3. Is there a significant relationship between CEO compensation (salary plus bonus) and the debt-to asset ratio at the low level of managerial discretion level in the U.S scheduled passenger airline industry?

Hypotheses

In testing the hypothesis this study will draw conclusions on the dollar amount

of CEO compensation (salary plus bonus) and whether or not the amount of

compensation is related to firm performance Hypotheses provide direction to the study, aid in differentiation between relevant and non-relevant facts, guides the most

appropriate research design, and provides a framework for the organization of

conclusions that result from the research (Cooper & Schindler, 2006) The use of

hypotheses testing involves two statistical hypotheses; the research hypothesis, which is usually symbolized by H1, and the null hypothesis, which is usually symbolized by Ho For the purpose of statistical analysis, the study’s hypotheses are presented in the null and alternative forms Statistical analysis allows the researcher to either accept or reject the null hypotheses The null and alternative hypotheses for this study are:

H01 (null) There is no significant relationship between CEO compensation and return on assets (ROA) at the low level of managerial discretion in the U.S

scheduled passenger airline industry

HA1 (alternative) There is a significant relationship between CEO

compensation and return on assets (ROA) at the low level of managerial discretion in the U.S scheduled passenger airline industry

H02 (null) There is no significant relationship between CEO compensation and

return on equity (ROE) at the low level of managerial discretion level in the U.S scheduled passenger airline industry

HA2 (alternative) There is no significant relationship between CEO

compensation and return on equity (ROE) at the low level of managerial discretion in the U.S scheduled passenger airline industry

H03 (null) There is no significant relationship between CEO compensation and the debt-to asset ratio at the low level of managerial discretion level in the U.S scheduled passenger airline industry

HA3 (alternative) There is no significant relationship between CEO

compensation and the debt-to asset ratio at the low level of managerial discretion in the U.S scheduled passenger airline industry

Significance of the Study The U.S airline industry can be viewed as a barometer for measuring the U.S economy as whole as the industry contributes significantly to the U.S economy

According to aviation and economic research consultants, in 2004 the aviation sector of the U.S economy collectively contributed $1.37 trillion of national output, supported 12.3 million U.S employees, and was responsible for $416 billion in personal earnings The majority of this impact was attributed to commercial aviation which collectively contributed $1.2 trillion in output, $380 billion in earnings and 11.4 million jobs (The Campbell-Hill Aviation Group, 2006) The Air Transport Association noted that Pulitzer Prize winner Daniel Yergin observed,

Every day, the airline industry propels the economic takeoff of our nation It is the great enabler, knitting together all corners of the country, facilitating the movement of people and goods that is the backbone of economic growth It also firmly embeds us in that awesome process of globalization that is defining the 21st century (ATA, 2007)

Results of this study may have a significant impact on stockholders and

stakeholders in their approach to CEO compensation Comparisons of CEO

compensation and firm performance in the U.S airline industry may aid those seeking

to invest in the industry as well as forward looking investment decisions by various groups interested in the U.S airline industry Smaller passenger air carriers may use the results of this study in their determination of the requirements necessary to generate higher revenue Furthermore, various industries may use the results of this study to examine the relationship between CEO compensation and firm performance in a

particular industry or across industries and across the three levels of managerial

discretion

Definitions and Key TermsThe following definitions and terms will be used throughout this study

CEO The Chief Executive Officer of the firm

CEO Compensation The annual salary plus bonus paid to the firms’ CEO Debt-to-Asset Ratio The ratio of total debt to total assets This is an indicator of the

leverage of the firm and the potential risks the company faces relative to its debt load

Managerial Discretion The range of latitude, actions, or options CEOs have in

making strategic decisions; high, medium or low

Return on Assets (ROA) The ratio of annual net income to total assets This is

an indicator of how much profit a company earns for every dollar of assets

Return on Equity (ROE) The ratio of annual net income to common equity

This is an indicator of rate of return on common stockholders’ investment

Revenue Passenger Mile (RPM) Revenue passenger mile is a measure of sales

or the volume of air passenger transportation A revenue passenger-mile is equal to one fare-paying passenger carried one mile

Assumptions and Limitations This study makes significant use of stockholder theory and agency theory as the foundation for its approach and consequently is limited by the theory itself According

to Veliyath and Bishop (1995), agency theory predicts that there is a conflict of interest between the CEO and the shareholders they represent because the CEO may act in his/her own self-interest to pursue goals that maximize their personal welfare

However, owners who are also managers of the firm do not have conflicts of interest in the management of the firm because the owners work for themselves thus, their well-being is directly tied to increasing their own personal wealth In most large

corporations, managers of the firm are not the owners of the firm; therefore agency theory plays an important role in many large U.S corporations

Stockholder theory assumes that there is a fiduciary responsibility between the managers of the firm and those who hold stock in the firm, i.e., the owners of the firm This fiduciary duty implies that firm managers maximize stockholder returns Velamuri and Venkataraman (2005) argue that when a firm’s managerial decisions are not in accordance with stockholder theory, the value of the firm’s stock can be immediately

and substantially devalued The case can be made that managerial decisions to award CEOs with exorbitant salaries and bonuses while firm performance and thus stock price decreases is not conducive to stockholder theory and implies that in agency theory there

is a conflict of interest between the CEO and the shareholders they represent

Other paradigms, such as stewardship theory, may provide alternative

approaches for understanding the effects of CEO compensation and firm performance The complexities of human factors are such that it is virtually impossible to take into account all such factors Indeed, many legal, industry, and organizational factors may also have an impact on CEO compensation, thus the firm’s subsequent performance Because this study is a study of the relationship between CEO compensation and firm performance in the U.S domestic scheduled passenger airline industry, generalizability may be limited due to nature of the sample under study In addition, secondary data have been gathered from publicly available sources such as annual reports in order to operationalize the concept of CEO compensation and firm performance in the U.S domestic scheduled passenger airline industry

Organization of the Study The remainder of this study is divided into four chapters Chapter 2 consists of a review of relevant literature Chapter 3 provides a description of the study’s

methodology Included in this chapter is an explanation of the sample design and the statistical procedures used in the analysis The study findings and analysis are

presented in Chapter 4, while Chapter 5 provides a detailed discussion of the analysis and findings, the conclusions from the study, as well as a discussion of possible areas for future research

CHAPTER 2: REVIEW OF THE LITERATURE

Introduction

A classic example of the principle-agent problem lies within publicly traded U.S corporations and CEO compensation The principle-agent problem posits that there is a conflict of interest when agents (managers) pursue their own objectives to the detriment of the principals’ (stockholders) goals because agents are hired by principals

to run the business on their behalf Stockholders typically want to maximize firm profit and stock price while managers may have other motives such as personal power and prestige Brigham and Houston (2004) argue that a publicly owned corporation “is owned by a relatively large number of individuals who are not actively involved in its management” (p 309) therefore, the principle-agent problem exists As agents,

managers are empowered to manage the financial resources advanced by stockholders and to do so “exclusively for the purposes delineated” (Hasnas, 1994, p 2) by their stockholders or principals Friedman (2002) argues that principals invest in firms to maximize the return on their investment; therefore management has a duty to not divert corporate funds away from the purposes expressively authorized by them

However, shareholders do not have perfect information regarding the actions of the CEO and the firm’s investment opportunities One would assume that corporations would undertake activities only when the benefit of an opportunity exceeds the cost of that opportunity Agency theory argues that when corporate ownership is widely held, the actions of senior management may depart from what is required to maximize shareholder returns Donaldson and Davis (1991) argue that because the objective of shareholders is to increase personal wealth, CEO compensation should be aligned with

shareholder wealth Wilhelm (1993) argues that agency theory provides a framework for analyzing the compensation schemes of CEOs where these officers are rewarded for making decisions that maximize shareholder wealth However, the goals of power, compensation maximization, and job security frequently present a divergence between the CEO and that of the shareholder

Publicly traded corporations are required by law to file financial statements with the Securities and Exchange Commission (SEC) In their annual proxy statements, corporations must disclose the total compensation of the five highest-paid executives BusinessWeek reported that in 1999, the top five corporate executives in the U.S earned

$1.2 billion (Reingold, 2000) During the five-year period between 1996 and 2000 average CEO pay (salary plus bonus) grew by 24 percent and total CEO compensation (salary, bonus, stock options and restricted stocks grants) increased 166 percent while corporate profits grew by only 16 percent during the same time period (Ackman, 2000) Various publications, information vendors, and consultants compile these data which comprise the basis for all public statistics on executive compensation Most studies of CEO compensation are not based on comprehensive statistics but are based on samples (Shorter, Jickling, & Raab, 2007) because no official estimates of executive pay exists although private entities make estimates based on publicly accessible data from

corporate annual statements (Shorter & Labonte, 2007)

The literature suggests that a major unknown factor in determining executive compensation is a common practice referred to as stealth compensation (Bebchuk, 2006) which is reported as compensation unrelated to firm performance such as bonuses, company perks, generous severance packages, golden parachutes, and executive

pensions Finkelstein and Hambrick (1988) argue that the factors involved in

determining executive compensation are often misleading because these components of

an executive’s compensation package may take many forms that are so complex, actual compensation may be distorted For example, a compensation package may include not only reported salary but bonuses, stock options, pension contributions, deferred income, benefits, long-term compensation, access to corporate jets, corporate vehicles, and payments for housing expenses

Disclosure of executive compensation for publicly traded companies began in the 1930s with the passage of the Securities Exchange Act Since that time, the

Securities and Exchange Commission (SEC) has modified its disclosure format to account for the increasingly complex and varied forms of compensation paid to

executives of publicly traded corporations Effective November 7, 2006, the SEC mandates the disclosure of the top five executive’s total compensation including the fair market value of all stock option grants and post-employment benefits and payments (Securities and Exchange Commission, September 8, 2006) Chairman of the House Financial Services Committee, Barney Frank, stated that he did not think the

government should be telling people what to pay [executives]… the shareholders should” He further commented that with regard to CEO compensation:

I do not think the boards of director’s work as effective independent checks They are not the fox guarding the hen house They are the hens guarding the rooster And I think the time has come to say we need the shareholders to do this … We’re saying let the people who own the companies go for it (Frank, 2006)

In his State of the Economy address on January 31, 2007, President Bush noted that the U S economy is based on public trust He further argued that owners of

corporations not the government should make the decisions regarding corporate

executive pay packages and “their compensation should be based on their success at … bringing value to their shareholders” President Bush stated that the recent ruling by the SEC should ensure transparency in executive compensation such that shareholders

“ought to be able to see with certainty the nature of the compensation packages for the people entrusted to run the companies”

Crumley (2006) argued that most of the previous research on executive

compensation has focused on the relationship between shareholder value and executive pay packages However, he argued that prior research on CEO compensation does not distinguish reward and punishment programs as well as all the factors used in

calculating executive compensation The author suggests that three basic elements are necessary for an efficient CEO compensation package First, a base salary consistent with firm size and firm performance; second, an incentive plan driven by firm

profitability; and third, a compensation plan based on price changes in the firm’s stock

Jensen and Murphy (1990b), argue that in the majority of publicly traded

corporations in the U.S., executive compensation is not dependent upon firm

performance The authors note that “on average, corporate America pays its most important leaders like bureaucrats” (p 138) They suggest that because of the virtually independent nature of executive compensation many CEOs do not maximize

shareholder wealth Their research was based on salary and bonus data for 2,505 CEOs

in 1,400 publicly traded corporations from 1975 through 1988 published in Forbes and

included in Standard & Poor’s Compustat database In addition, data on stock options and stock ownership for CEOs of the 430 largest publicly held companies in 1988 were included Their analysis revealed that the most important factor between executive

compensation and shareholder wealth was CEO stock ownership although their study found that CEO stock ownership as a percentage of corporate value had decreased In order to create incentives for CEOs to maximize shareholder wealth, the authors offered three propositions First, boards of directors should require that CEOs own a substantial amount of company stock as measured by the percentage of company stock outstanding

as this will ensure a “direct and powerful feedback effect” (p 141) Second,

compensation packages including salaries, bonus, and stock options should be structured such that superior performance is highly rewarded and poor performance is highly penalized Third, it is imperative that boards of directors follow through on the threat of dismissal for poor firm performance

Rupp and Smith (2002) looked at a sample of 76 U.S companies whose primary SIC major group was the metals industry The sample was chosen from the FIS online database The authors theorized that firms in the metals industry of similar size and performance would have different levels of executive compensation Their study

focused only on CEO cash compensation as determined by base salary plus bonus The authors hypothesized that the variances could be predicted based upon firm age,

percentage of shares owned by the board of directors, percentage of insiders on the board of directors, firm diversity as measured by the number of different SIC codes each firm had business in, number of employees, revenue, ROA, ROE, EBITDA, CEO tenure, and the total years the CEO had been with the company Using Spearman rank correlations, the authors found that CEO bonuses were highly correlated with firm age, ROA, ROE, and EBITDA A significant negative correlation was found between CEO base salaries when the CEO was also Chairman of the Board The authors concluded that when the number of insiders on the board increased, revenues and EBITDA