Abstract We use Tobin’s q models of investments to estimate the relationship between corporate governance and the level of innovative activity. Simple ordinary least squares (OLS) models suggest that poor governance reduces innovative activity. However, OLS results are sensitive to controlling for serial correlation, unobserved effects, or using instrumental variables to control simultaneity. Controlling for these effects substantially reduces or eliminates the relationship between governance and innovative activity.

This paper examines how executive compensation influences the market value of the firm's assets. After controlling for endogeneity, we find that boards have set the incentive to incur risk (vega) to maximize shareholder value, but that incentives to increase returns (delta) do not maximize shareholder value. We also find that current levels of cash compensation do not maximize shareholder value. Finally, we consider the moneyness of stock options. We find that the level of at- and out-of-the money options maximize shareholder value, but the level of in-the money options do not maximize shareholder value.

When financial market frictions exist, executives may have to decide which investment activities to reduce when internal funds decrease. Expenditures on research and development (R&D) may be particularly vulnerable because of the long-term nature of innovative activity. We find that equity compensation is associated with lower levels of firm R&D expenditures. Rewarding executives to incur more risk has little effect on R&D expenditures, but rewarding executives for higher returns reduces R&D expenditures and makes R&D expenditures more sensitive to financial market frictions. In contrast, cash compensation reduces the sensitivity of R&D expenditures to financial market frictions.