Companies can potentially use compensation peer groups to inflate pay by choosing peers that are larger, choosing a high target pay percentile, or choosing peer firms with high pay. Although peers are largely selected based on characteristics that reflect the labor market for managerial talent, we find that peer groups are constructed in a manner that biases compensation upward, particularly in firms outside the Standard & Poor's (S&P) 500. Pay increases close only about one-third of the gap between the pay of the Chief Executive Officer (CEO) and the peer group, however, suggesting that boards exercise discretion in adjusting compensation. Preliminary evidence suggests that increased disclosure has reduced the biases in peer group choice.

ABSTRACT Exercises of employee stock options generate substantial cash inflows to the firm. These cash inflows substitute for costly external finance in those states of the world in which the demand for investment is high. Using the fact that the proceeds from option exercises exhibit a distinct nonlinearity around the point where options fall out of the money, we estimate that firms increase investment by $0.34 for each dollar received from the exercise of stock options. Firms that face higher external financing costs allocate more of the proceeds from option exercises to investment.