Cost Of Governance Relationship With Firms Profitability

NUST Business School

Relationship of Cost of
Governance and Firm’s
Profitability
MBA Thesis

10/16/2009

Muhammad Jawad Iqbal Khan

2008-NUST-MBA-26

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Relationship of Cost of Governance and Firm’s Profitability

By

Muhammad Jawad Iqbal Khan

A Thesis Submitted to the Graduate Faculty of


In Partial Fulfilment of the Requirements for the degree of

Masters of Business Administration

(MBA)

Major Subject: Finance and Investment

Approved:

_________________________________________

Mr. Salman Shehzad, Thesis Advisor


H-12 Sector, Islamabad

October, 2009

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Relationship of Cost of Governance and Firm’s 2009
Profitability

© Copyright 2009

By

All Rights Reserved

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ACKNOWLEDGEMENT

I am thankful to Almighty Allah for blessing me with strength and knowledge to con duct
this research.

I am grateful to my Thesis Advisor , Mr.Salman Shehzad, for being patient with me and
advising me all along the research.

I am grateful to Dr.Raheel Gohar for helping me in the research through his own
research input and guidance. I am extremely thankful to Mr.Fazli Azam for providing me
with relevant research papers, as he gathered them for his own research paper.

I have taken a lot of guidance from the research paper of Ms.Rozina Shaheen and her
lectures on research methodology in BBA course were extremely helpful.

Mr.Shoaib Qureshi will always be the one who introduced me to Corporate Governance
and helped me to get the literature from IFC, World Bank. His lectures through
Corporate Governance course in MBA are a lightening tower for me in this research.

All the research papers in the bibliography are either taken from JSTOR.com or www.ssrn.com.
Any author who considers his/her work was not referenced properly can contact the author
(jawadiqbalkhan86@yahoo.com), so that it is updated accordingly. I am extremely thankful to
all authors for their valuable input into the literature for Corporate Governance, which helped
me throughout my research.

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ABSTRACT

Corporate Governance is considered as the basic pillar for the long term existence and stability
of the firms. Recent falls of one of the biggest corporations in world like Enron and World Call
sparked the debate on the importance and practical application of better governance
mechanisms in the corporations. The literature has been comprehensively added with the
experiences of different industrial countries and the recent collapse of subprime mortgage and
subsequent bankruptcies of numerous banks and corporations including Lehman Brothers a nd
mortgage giants like Fannie Mae in USA.

In Pakistan, Code of Corporate Governance 2002 was a major milestone and different studies
have been conducted. This research covers 9 industries and 22 firms including banks, insurance,
engineering, cement, fertilizers and chemicals. The focus on the research is to establish a
significant relationship between the compensation paid for the mechanisms of Corporate
Governance i.e. Directors, CEO and Senior Executives. The compensation data is tested for
6significant relationship with company’s' performance variables including Sales, Assets, Pre Tax
Profit, Operating Cash Flows, Selling and Administrative Expenses, Profit as percentage of Sales
and Return on Assets.

The relationships signify the fact that companies pay the governance bodies in the firm based
upon the firms' performance. Different variables are used as indicator of performance in
different companies and industries and differences also exists within industries. This study is
statistically significant for the time period of 2003-2007. These results can be used to improve
the corporate governance compensation paid and profitability generated by the firms. The
research confirms the significant relationships between different stakeholders compensation in
the organization and performance indicators. Different industries pay according to their own
business cycles and also different companies compensate respectively in the same industry as
well. Thus compensation management is the solution to Principle Agent Problem in the
Corporate Governance framework and understanding it will help companies solve it.

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DISCLAIMER

This report is compiled in partial fulfilment of the requirements of Masters of Business
Administration Degree at NUST Business School, Islamabad.

The author has tried his best to avoid any kind of plagiarism. All sources are cited in the
foot notes, references and bibliography section according to the use of the work of
other authors. In case, any one is concerned about any idea or reference mentioned in
this report, the author will welcome any such query and try to resolve it without any
objection.

In any case, the author has not intended to represent the intellectual property of other
people as his own work.

The author can be contacted in case of any issue, through NUST Business School, H-12
Sector, Islamabad, Pakistan.

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Table of Contents

1 Introduction................................................................................................................................1
1.1 Background of Corporate Governance...................................................................................1
1.2 History ................................................................................................................................2
1.2.1 16th Century .................................................................................................................2
1.2.2 17thCentury.................................................................................................................2
1.2.3 1844 ............................................................................................................................2
1.2.4 1931 ............................................................................................................................2
1.2.5 Early 1990s...................................................................................................................3
1.2.6 2002 -2004 ...................................................................................................................3
1.2.7 2004-2007....................................................................................................................3
1.3 Corporate Governance Defined ............................................................................................4
1.4 Pillars of Corporate Governance ...........................................................................................4
1.5 Compensation and Corporate Governance ............................................................................5
2 Literature Review ........................................................................................................................8
3 Research methodology ..............................................................................................................14
3.1 Topic.................................................................................................................................14
3.2 Aim of Study......................................................................................................................14
3.3 Hypothesis ........................................................................................................................14
3.4 Research Design & Methodology ........................................................................................15
3.4.1 Analytical ...................................................................................................................15
3.4.2 Fundamental ..............................................................................................................15
3.4.3 Qualitative and Quantitative .......................................................................................15
3.4.4 Empirical ....................................................................................................................15
3.4.5 Deductive...................................................................................................................15
3.4.6 Co-relational Study .....................................................................................................15
3.4.7 Non Contrived & Minimal Interference ........................................................................16
3.4.8 Unit of Analysis...........................................................................................................16
3.4.9 Cross sectional Time Horizon.......................................................................................16

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3.5 Sampling Tools ..................................................................................................................16
3.5.1 Sample.......................................................................................................................16
3.5.2 Time Duration ............................................................................................................17
3.5.3 Sources of Data ..........................................................................................................17
3.6 Variables Identified............................................................................................................17
3.6.1 Firm Performance Variables ........................................................................................17
3.7 Methods used to test the relationship between variables ....................................................18
3.7.1 Spearman Correlation.................................................................................................18
3.7.2 Pearson Correlation....................................................................................................18
3.7.3 Regression Equation ...................................................................................................19
3.7.4 Independent one-sample t-test ...................................................................................19
3.8 Data Analysis .....................................................................................................................20
3.8.1 Software ....................................................................................................................20
3.9 Framework........................................................................................................................21
4 Analysis ....................................................................................................................................22
4.1 CEO Compensation ............................................................................................................22
4.2 Directors Compensation.....................................................................................................22
4.3 Executives Compensation...................................................................................................23
4.4 Total Compensation...........................................................................................................24
5 H1 Compensation for Governance is related to the Firms’ Performance........................................25
5.1 Regression of Variables and Results ....................................................................................27
6 H2 Different Industries follow different performance variables for compensation .........................29
6.1 Industry Wise Correlation Analysis ......................................................................................29
7 Conclusion ................................................................................................................................36
8 Limitations................................................................................................................................38
9 Appendix .................................................................................................................................... I

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List of Figures
Figure I CEO Compensation ...............................................................................................................22
Figure II Director’s Compensation ......................................................................................................23
Figure III Executive Compensation .....................................................................................................24
Figure IV Total Compensation Paid by the Company ...........................................................................24
Figure V Sample Summarized Correlation Values ................................................................................25
Figure VI Industry Wise Correlation Summary.....................................................................................32
Figure VII Regression of Total CEO Compensation with Sales ................................................................. I
Figure VIII Regression of Total CEO Compensation with Assets .............................................................II
Figure IX Regression of Total CEO Compensation with Pre Tax Profit....................................................III
Figure X Regression of Total CEO Compensation with Operating Cash Flow .......................................... IV
Figure XI Regression of Total CEO Compensation with S&A Expenses.................................................... V
Figure XII Regression of Total CEO Compensation with Profit Margin ................................................... VI
Figure XIII Regression of Total Director's Compensation with Sales..................................................... VII
Figure XIV Regression of Total Director's Compensation with Assets ...................................................VIII
Figure XV Regression of Total Director's Compensation with Pre Tax Profit ...........................................IX
Figure XVI Regression of Total Director's Compensation with Operating Cash Flow................................ X
Figure XVII Regression of Total Director's Compensation with S&A Expenses ........................................XI
Figure XVIII Regression of Total Director's Compensation with Profit Margin........................................XII
Figure XIX Regression of Total Executive Compensation with Sales .....................................................XIII
Figure XX Regression of Total Executive Compensation with Asset..................................................... XIV
Figure XXI Regression of Total Executive Compensation with Pre Tax Profit......................................... XV
Figure XXII Regression of Total Executive Compensation with Operating Cash Flow ............................ XVI
Figure XXIII Regression of Total Executive Compensation with S&A Expenses .....................................XVII
Figure XXIV Regression of Total Executive Compensation with Profit Margin.....................................XVIII
Figure XXV Regression of Total Compensation with Sales ...................................................................XIX
Figure XXVI Regression of Total Compensation with Assets .................................................................XX
Figure XXVII Regression of Total Compensation with Pre Tax Profit.....................................................XXI
Figure XXVIII Regression of Total Compensation with Operating Cash Flow ........................................XXII
Figure XXIX Regression of Total Compensation with S&A Expenses ................................................... XXIII
Figure XXX Regression of Total Compensation with Profit Margin .....................................................XXIV

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1 Introduction
This Chapter focuses on the history of Corporate Governance, its basic premise and the
relationship of Corporate Governance with the Compensation Management, highlighting
different common types of Compensation mechanisms.

1.1 Background of Corporate Governance
Corporate Governance has taken major importance in the literature and business arena
after the fall of Enron and World Call. Celebrated as one of the most innovative
companies in 1990, 1 Enron collapse was an eye-opener at many fronts, from regulatory
failures to Auditor fraudulent activities. Regulatory Frameworks were present before
Enron and World Call governance fiasco, such as Cadbury Act in UK and OECD Principles
on Corporate Governance, but it forced United States to develop stricter regulations and
control through Sarbanes Oxley Act.

In Pakistan, in the wake of global regulatory
“The system by which
actions, Securities and Exchange Commission of
Accounting Officers carry out
Pakistan issued Code of Corporate Gov ernance
their responsibility for ensuring
in 2002. This code was the first step towards
that effective management
the goal, and all listed companies followed the
systems, including financial
code for regulatory compliance, but only a few
monitoring and control systems,
of them followed it for the improvement of
have been put in place.”
company’s governance and increased
profitability. Several cases of failure of HM Treasury, U.K.

Corporate Governance in the companies which
were publishing adherence to the Code in their
Annual reports are reported in media.

1
[Online] www.newsweek.com/id/44191

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1.2 History

1.2.1 16th Century
The Merchant of Venice Act 1 Scene 1

Merchants feared for the safety of their ships:

Who sets the direction of the journey?
How to exercise control? Oversight?
How to protect interests of owners?

1.2.2 17thCentury
The East India Company introduces a Court of Directors, separating ownership and
control (U.K., the Netherlands) to oversee the company’s management in India.

1.2.2.1 1720
In the UK, governance was enhanced with much regulation following the South Sea
Bubble in 1720 with the formation of the incorporated joint stock company (amongst
other things)

1.2.2.2 1776
Adam Smith in the “Wealth of Nations” warns of weak controls over and incentives for
management (U.K.)

1.2.3 1844
First Joint Stock Company Act (U.K.)

1.2.4 1931
Berle and Means publish their seminal work “The Modern Corporation and Private Property”
(U.S.)

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1.2.5 Early 1990s
“Corpora te Governance is a series of
First wave of corporate scandals in the U.K. (Polly Peck,
stru ctu res and pro cesses for the
BCCI and Maxwell), followed by: direction and control of a
company.”
Stagnation
Privatization Sir Adrian Cadbury

Globalization
Demographic pressures (pension bomb)

1.2.5.1 1992 -1997
First corporate governance codes in the U.K. (Cadbury), followed by, inter alia, S. Africa (King),
France (Viénot), the Netherlands (Peters) and finally the U.K. (Combined Code).

1.2.5.2 1999
“In general, *…+ corporate
OECD Publishes first international benchmark, the
governance structures and
OECD Principles of Corporate Governance practices should protect and
enhance accountability to, and
1.2.6 2002 -2004 ensure equal financial treatment
New wave of corporate scandals in the U.S. (Enron, of, shareholders.”
The Council of Institutional
WorldCom) and E.U. (Ahold, Hollinger, Parmalat) lead
Investors.
new corporate governance regulations (Sarbanes-
Oxley)

1.2.7 2004-2007
New rise in shareholder activism by pension funds, but likewise, hedge funds and private equity
exercise influence on corporate governance agenda

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1.3 Corporate Governance Defined
OECD Principals of Corporate Governance defines it as following:

"Corporate governance is the system by which business corporations are directed and
controlled. The corporate governance structure specifies the distribution of rights and
responsibilities among different participants in the corporation, such as the board, managers,
shareholders and other stakeholders, and spells out the rules and procedures for making
decisions on corporate affairs. By doing this, it also provides the structure through which the
company objectives are set, and the means of attaining those objectives and monitoring
performance. “

Corporate Governance 2 is the

System by which corporations are directed & controlled
Structure that specifies the distribution of rights & responsibilities
Among corporate participants, i.e. the board, managers and SHs
Spells out the rules and procedures for decision-making
Provides structure for setting and attaining company objectives, and monitoring
company performance.

1.4 Pillars of Corporate Governance
Following are the four pillars3 of Corporate Governance

1. Accountability
2. Fairness
3. Transparency
4. Responsibility

2
IFC, “Module 1-Introduction: Corpo rations and Corpora te Governance”. (Slide 20), 2009.
3
IFC, “Module 1-Introduction: Corpo rations and Corpora te Governance”. (Slide 26), 2009.

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1.5 Compensation and Corporate Governance
The management and shareholders relationship can be understood from the perspective of
Principal-Agent Relationship. The economic theory 4 suggests that the appointment of agents
and compensation managements should be in the control of the Principal.

Major responsibility5 lies on the Directors for the compensation management for the executive
management. But who sets the compensation for the directors?? Generally it will be
understandable that directors have ownership stake in the firm, so they will try to focus on the
benefit of shareholders. Perhaps we should not let any one set of stakeholders 6 to decide the
compensation of executives which impacts all the stake holders. Considering shareholders are
the prime stake holders due to the reason that they will lose out most in case of total
bankruptcy due to claim after the bond holders of the firms.

Fred R. Kaen argued that to the extent that managerial compensation can be linked to indirect
variables like number of hours put in work, instead of financial variables like Pre Tax Profit, it
will reduce the opportunities to shirk by the management. Managers still prefer to use the
quantitative variables like return on equity or profit margins for compensation, as these
variables increase the stock price of the company which is beneficial for the share holders. Still
the problem persists, as how to differentiate between the variables which can be influencing
the managerial performance to those which are general business cycle and luck factors.

Generally this paradox of variable identification is relatively made easier through using
comparative or relative compensation schemes with respect to the industry. This way, firm can

4
Aditya Parthasarathy, Krishnakumar Menon and Debashish Bhattacherjee, 2006. Executive Co mpensation, Firm
Performance and Corporate Governance: An Empirical Analysis . Indian Institute of Management Calcutta .
5
Fred R. Kaen, 2003. “A Blu eprin t for Corpo rate Governance Strategy, Accountability, and the Preservation of
Shareholder Value”. Chapter 8- Corporate Governance and Managerial Compensation, pg 117. Published by
American Management Association.
6
This topic is influenced by Fred R.Kaen, 2003 “A Blueprin t for Co rporate Governance Stra tegy, Accountability, and
the Preservation of Shareholder Value”. The views expressed are of the author and should not be counted as a
criticism or negation of the views of Fred. R. Kaen. Author is briefly reviewing his work on compensation
management in his book.

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identify if the management is really working for company better performance or is it only
market forces which are helping them in achieving the target performance.

Common compensation scheme in the world is i.e. a fixed base salary is paid to the executive
and further compensation is linked to the yearly performance in form of bonuses and
increments. A long term component is also used to keep the executives also tuned towards long
term profitability of the firm by giving them stock options or long term performance variables.
In Pakistan, the two component salary is more prevalent where management is given fixed base
salary and variable bonuses. Companies do try to include stocks in the compensation of the
management, but it is relatively an outdated version of ESOP in Pakistan, than prevalent in
European or American Firms. The analysis of the companies indicates that firms pay according
to two component plans.

The short term incentive plans linked to company performance i.e. bonus based upon Pre Tax
Profit values have multiple short comings like accounting manipulation to window dress the
results for higher bonuses, budgeting issues like depreciation calculations are manipulated for
increasing profit and potential gaming behavior.

The long term incentive plans like stock options comes with own set of problems. The recording
of stock options as expenses or otherwise creates a huge difference in the income treatments.
Firms tend to abusively manipulate the earnings when stock options are recorded as expenses.

EVA or Earned Value Analysis7 is a more popular but slightly technical way of calculating
managerial performance. It can be simply understood as the value added by the manager to the
firm over and above the cost of capital for the firm. Managers are paid bonuses if the EVA is
positive for the firm. It can be calculated by reducing the net income by the equity capital
financing charge as determined by calculating the cost of equity for the shareholders and
applied on the assets under the management control.

7
EVA or Economic Value Added is a trade marked product of Stern Stewart & Company.

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The market and investors in Pakistan are not technically knowledgeable about the exercise
price determination impact on the option valuation and how these derivates can be adjusted to
suit the needs of the management, while being neutral and unbiased on the face value.

Thus, the market is focusing on the two tier compensation management which is easily
understandable by the stakeholders.

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2 Literature Review
This chapter provides an overview on the literature published on the Corporate Governance and
Firm’s Profitability. It also focuses on the specific relationships identified by researchers between
the compensation management and firm’s profitability.

Following 8 are some important statistics and facts regarding Corporate Governance

“Corporate Governance streamlines business processes, leading to better operating
performance and lower capital expenditures”. (Gompers, Ishii and Metrick, Corporate
Governance and Equity Prices, August 2001).
“Improves the company’s ROCE, with companies in the top cg quartile averaging 33%
and those in the bottom 15% ROCE”. (Credit Lyonnais SA, 2001).
“Better share price performance, higher profitability, larger dividend payouts, and lower
risk levels than industry peers”. (Lawrence Brown, Georgia State University, Sept. 2003).
“There appears to be a substantial and statistically significant correlation between an
active, independent board and superior corporate governance performance”. (Mac
Avoy /Millstein, The Recurrent Crisis in Corporate Governance, 2004).

Financial reforms during 1990s have influenced the pattern of capital structure, dividend policy,
risk premia, and compliances to corporate governance (Nishat, 1999). Rozina and Nishat show
that poorly governed firms (i.e., those with low Gov Scores) have lower operating performance,
lower valuations, and pay out less cash to their shareholders, while better-governed firms have
higher operating performance, higher valuations, and pay out more cash to their shareholders.

Anderson et al. (2004) show that the cost of debt is lower for larger boards, presumably
because creditors view these firms as having more effective monitors of their financial
accounting processes.

8
IFC, “Module 1-Introduction: Corpo rations and Corpora te Governance”.

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Shleifer & Vishny (1997) defined Corporate Governance in terms of suppliers of funds 9 as
“Corporate Governance deals with the ways in which suppliers of finance to corporations assure
themselves of getting a return on their investment”.

They also raise the following questions in their research

How do the suppliers of finance get managers to return some of the profits to them?
How do they make sure that managers do not steal the capital they supply or invest it in
bad projects?
How do suppliers of finance control managers?

Jensen (1986) was of the view that managers reinvest the free cash flows rather returning it
back to the investors by using oil industry of 1980s. Oil Producers used free cash flows to
search for new unproven oil reserves instead of buying cheaper proven reserves, just to
maintain the exploratory activities to satisfy their empire building desires. The difference was
$16 per barrel additional cost of investors. The least costly10 of these costs to investors are
consumption of perquisites such as company airplanes (Burrough and Helyar, 1990).

For example, Victor Posner, a Miami financier, received in 1985 over $8 million in salary from
DWG; a public company he controlled, at the time the company was losing money (New York
Times, June 23, 1986).

Managers tend to pursue the projects which maximize their interest against those which will
maximize shareholders interest, Grossman and Hart (1988) described these benefits as the
private benefits of control.

9
Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2
. June 1997.
10
Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No.
2 . June 1997.

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The principal agent contract 11 between the shareholders and management of the firm is of
great importance. It also creates a lot of problem when issue of residual rights is considered.
Principal wants to retain all the residual rights for situations which are not fully explained by the
contract, but they cannot do so properly due to lack of insight and experience and thus end up
giving up these residual rights to the agent, who in turn uses them as per their own discretion,
thus violating the basic premise of principal-agent contract. Jensen and Meckling (1976) argued
that managers 12 will undertake inefficient projects instead of returning the free cash flow and
this will result in ex post inefficiency.

Walkling and Long (1984) proposed that managers tend to resist less to a value increasing
takeover if they have direct financial interest through share ownership o r golden parachutes, or
they will get to keep their jobs. DeAngelo and Rice (1983) and Jarrell and Poulsen (1988a)
suggest13 that public announcements of certain anti-takeover amendments to corporate
charters, such as super-majority provisions requiring more than 50 percent of the votes to
change corporate boards, reduce shareholder wealth. Ryngaert (1988) and Malatesta and
Walkling (1988) find that, for firms who have experienced challenges to management control,
the adoption of poison pills-which are devices to make takeovers extremely costly without
target management's consent-also reduce shareholder wealth. Comment and Schwert (1995),
however, question the event study evidence given the higher frequency of takeovers among
firms with poison pills in place.

Board of Directors only 14 changes a management when a severe performance disaster occurs
(Warner, Watts, and Wruck (1988)). Research on Japan and Germany by Kaplan (1994 a, b)
indicate that board of directors act passively unless in extreme situations a nd Mace (1971) and

11
2 . June 1997.
12
2 . June 1997.
13
2 . June 1997.
14
2 . June 1997.

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Jensen (1993) are of view that as general rule corporate boards are influenced by management
in United States.

Roe (1994) found that large shareholding is relatively uncommon due to legal restriction on
high ownership in United States. However, the ownership is not completely diversified
(Eisenberg (1976), Demsetz (1983), Shleifer and Vishny (1986b)).

Manne (1965), Jensen (1988), Scharfstein (1988) suggest that takeovers address the
governance issues. Takeovers increase the combined value of both firms and create synergies
(Jensen and Ruback (1983)). It is also found out by Palepu (1985), Morck, Shleifer, and Vishny
(1988a, 1989) that takeover targets are often poorly performing firms.

Anderson, Bates, Bizjak and Lemmon (2000) suggest15 that structure of corporate governance is
sensitive to level of diversification. Diversified firms have higher fraction of outsiders on their
board, similar ownership by outside block holders and a similar sensitivity of managerial
turnover to performance relative to their single segment counterparts.

Kato and Long (2005) concluded from their research 16 on Chinese listed firms that

(i) Even if the firm is listed in Stock Exchanges, there is no significant and negative
link between CEO turnover and firm performance unless the listing is
accompanied by an ownership change from state to private
(ii) The presence of a large controlling shareholder makes CEO turnover more
sensitive to firm performance
(iii) The appointment of independent directors enhances turnover-performance
sensitivities;
(iv) CEO turnover-performance sensitivities are weaker for listed firms with CEOs who
also hold positions in the controlling shareholders

15
Ronald C. Anderson, Thomas W. Bates, John M. Bizjak, Michael L. Lemmon, “Corpora te Governance and Firm
Diversification”, Financial Management, Vol. 29, No. 1 (Spring, 2000), pp. 5-22.
16
Takao Kato and Cheryl Long, “CEO Turnover, Firm Perfo rman ce, and Corpo rate Governan ce in Chinese Listed
Firms”,March 2005.

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(v) Firm performance will improve significantly after the replacement of the CEO and
the improvement will be greater for privately controlled firms than for state
controlled firms.

Ishii and Metrick (GIM, 2003) find that stock returns of firms with strong shareholder rights
outperform, on a risk-adjusted basis, returns of firms with weak shareholder rights by 8.5
percent per year during this decade.

(Parthasarathy, Menon and Bhattacherjee, 2006) argue that none of the profitability measures
is significant determinant of total CEO pay. Firm Size is a significant variable for the
understanding of Total CEO Pay and the proportion of variable or incentive pays that a CEO
receives. CEOs who are owners or promoters of the firm receive higher compensation as
compared to peer CEOs in the industry as the incentive to work for the company is more these
CEOs.

(Kato and Long, 2005) Among other firm performance measures, it is found that sales growth is
linked to executive compensation in China’s listed firms and those Chinese executives are
penalized for making negative profit although they are neither penalized nor rewarded for
changes in profit in so far as it is positive.

David Dicks, 2009 argues that pay and governance are substitutes. If you increase the
governance, it will reduce the cost of compensation for the management or vice versa so that
management is focused on the shareholders’ wealth maximization either through higher
compensation or higher governance. The CEO compensation is increasing with the firm size
while the pay- performance sensitivity decreases in firm size. The cost of governance for
smaller firms is high, so it reduces the value of the firm. The optimal corporate governance
regulation is ignoring the small firms.

(Bebchuk, Fried and Walker, 2002)Executive Compensation is viewed as an arm’s length
bargaining by the Principal with the Agent, while in practice executives do have a substantial
influence on setting up their own compensation, thus seeking rent from the firm. Thus

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compensation management is not the solution to the Principal Agent problem; rather it is a
problem in itself and aggravates the complexity of the relationship. It is concluded that
management influences the compensation management process for there own benefit.

Stephan Sapp, 2007 Concludes that family owned firms and firms with a controlling shareholder
pay their CEOs less. Weaker Boards or where CEO dominates the Board, the compensation paid
to the CEO is higher than deserved by him by industry norms. If the CEO is the chairman of the
board, it increases the executive compensation and if he has the shareholding of the company,
it reduces the compensation.

Christian and Walker, 2008 analyze the effect of committee formation on how corporate
boards perform two main functions: setting CEO pay and overseeing the financial reporting
process. The stock based incentive schemes induces the CEO to manipulate earning for the
extra compensation. If the compensation management is up to the Board, then they tend to
decide an insensitive compensation scheme to reduce the subsequent monitoring. The
formation of compensation committee also creates some problems as the burden of oversight
is borne by the audit committee for the compensation management.

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3 Research methodology
This chapter details the methodology used for the research. The theoretical framework,
hypothesis and nature of study are detailed in this section.

3.1 Topic
The topic for research is

Relationship of Cost of Governance and Firm’s Profitability

(Cost of Governance is only related to the compensation paid to the CEO, Directors, Executives
and Total Compensation paid to the Firm. It do not include other costs of implementation of
governance, as values are taken from Annual Report which do not detail such private
information for the firm)

3.2 Aim of Study
The aim of study is to find out the relationship between the efforts done by a firm to improve
its corporate governance and its impact on profitability. By linking the salaries of the executive
team and directors to the performance of the firm, it can be identified if such link is strictly
followed by the companies or not.

3.3 Hypothesis
H1- Compensation for Governance is related to the Firms’ Performance

The hypothesis will focus on identifying the relationship between the variables given below.
The significance of the results will be depicted through regression analysis. The objective is to
find out a significant relationship between the two sets of variables.

H2- Different Industries follow different performance variables for compensation

The hypothesis will focus on identifying the differences in the compensation paid to different
stakeholders in the governance mechanism across different industries. The objective is to

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determine that companies adjust the compensation management to suit their business needs
and cycles.

3.4 Research Design & Methodology

3.4.1 Analytical
The research is analytical as secondary data of company’s performance from their annual
financial statements will be used along with other sources to identify critical trends and
evaluate them for statistical significance.

3.4.2 Fundamental
It is a fundamental research as solution to a particular problem is not searched. A general
understanding of the corporate governance relationship with the firm’s performance is the
basic purpose of the research.

3.4.3 Qualitative and Quantitative
It is a mix of qualitative and quantitative research, as corporate governance val ues are to be
developed by the researched. The theoretical analysis of the phenomenon governing corporate
governance in a firm is done through the qualitative research. The statistical significance for the
phenomenon is calculated through quantitative research.

3.4.4 Empirical
The research study is empirical in nature. It is based on observations from the real life
companies and will be analyzed through statistical measures to confirm or reject the
hypothesis, which are representatives of theoretical analysis.

3.4.5 Deductive
This study is deductive in nature. Theoretical background is formed through the literature
review, which results in hypothesis building. Data is collected for the testing of hypothesis and
results are discussed to confirm or reject the hypothesis.

3.4.6 Co-relational Study
The study is co-relational as correlation between corporate governance and firm performance
is checked.

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3.4.7 Non Contrived & Minimal Interference
The study is non- contrived as the interference of the researcher is minimum. This is due to the
fact that performance data of firms is already published and past data is used to analyze the
relationship between corporate governance and firm’s performance.

3.4.8 Unit of Analysis
The unit of analysis is group. Group of companies are analyzed collectively after their results are
obtained from statistical tests.

3.4.9 Cross sectional Time Horizon
The data is collected for the selected sample companies once in the start, and then this data is
used for hypothesis testing and analysis.

3.5 Sampling Tools

3.5.1 Sample
The sample is taken from listed companies at Karachi Stock Exchange. Priority is given to 100
Companies in the KSE 100 Index as of 1 st July 2009. Yearly Annual Reports of the companies are
used for data collection.

The companies included in the research according to industries are as following

Industry Company
1 Insurance Adamjee Insurance
2 Insurance EFU life Insurance limited
3 Banks Allied Bank Limited
4 Banks Askari Bank Limited
5 Banks Bank Alfalah Limited
6 Banks Bank Alhabib Limited
7 Banks Bank of Punjab Limited
8 Cement Best Way Cement
9 Cement DG Cement
10 Cement Fauji Cement
11 Cement Lucky Cement

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12 Fertilizer Fauji Fertilizer Company Limited
13 Chemicals ICI Pakistan Limited
14 Automobiles Indus Motors Company Limited
15 Automobiles Atlas Honda Company Limited
16 FMCG Nestle Pakistan Limited
17 Oil and Gas OGDCL
18 Oil and Gas SNGPL
19 Oil and Gas Pakistan OilFields
20 Engineering Pak Elektron Limited
21 Engineering Siemens Engineering Limited
22 Tobbacco Pakistan Tobacco

3.5.2 Time Duration
The time duration is 2004-2007 which makes a time period of four years.

3.5.3 Sources of Data
The secondary source of data is Companies Annual reports for financial performance and CG
variables. Stock prices data is taken from KSE website and Business Recorder website.

3.6 Variables Identified

3.6.1 Firm Performance Variables
The variables are grouped together in two categories

1. Compensation for Governance
a. Managerial Compensation
b. Director’s Fee
c. Allowances and Perquisites
d. Total Compensation for the year
2. Firm’s Performance
a. Sales
b. Assets
c. Operating Cash Flow

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d. Pre Tax Profit
e. Selling and Administrative Expenses
f. Profit Margin
g. Return on Assets

3.7 Methods used to test the relationship between variables
Using Pearson and Spearman correlations for governance score and firms profitability.

3.7.1 Spearman Correlation
In principle, ρ is simply a special case of the Pearson product-moment coefficient in which two
sets of data Xi and Yi are converted to rankings x i and yi before calculating the coefficient. In
practice, however, a simpler procedure is normally used to calculate ρ. The raw scores are
converted to ranks, and the differences di between the ranks of each observation on the two
variables are calculated.

If there are no tied ranks, then ρ is given by:

where:

di = xi − yi = the difference between the ranks of corresponding values Xi and Yi, and

n = the number of values in each data set (same for both sets).

3.7.2 Pearson Correlation
The statistic is defined as the sum of the products of the standard scores of the two measures
divided by the degrees of freedom. Based on a sample of paired data (Xi, Yi), the sample
Pearson correlation coefficient can be calculated as

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where

are the standard score, sample mean, and sample standard deviation (calculated using n − 1 in
the denominator).

1. Regression analysis for variables relationship.

3.7.3 Regression Equation
The regression equation deals with the following variables:

The unknown parameters denoted as β; this may be a scalar or a vector of length k.
The independent variables X.
The dependent variable, Y.

Regression equation is a function of variables X and β.

The user of regression analysis must make an intelligent guess about this function.

2. T- Test for significance of variables used for the model

3.7.4 Independent one-sample t-test
In testing the null hypothesis that the populations mean is equal to a specified value μ0, one
uses the statistic

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where s is the sample standard deviation of the sample and n is the sample size. The deg rees of
freedom used in this test is n − 1.

3.7.4.1 Slope of a regression line
Suppose one is fitting the model

where xi, i = 1, ..., n are known, α and β are unknown, and εi are independent normally
distributed random errors with expected value 0 and unknown variance σ2, and Yi, i = 1, ..., n
are observed. It is desired to test the null hypothesis that the slope β is equal to some specified
value β0 (often taken to be 0, in which case the hypothesis is that x and y are unrelated).

3.8 Data Analysis

3.8.1 Software
The software used is MS Excel for data analysis, MS Word for Report and MS Power Point for
Presentations.

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3.9 Framework

Cost of Corporate Governance and Firm’s Performance

Cost of Governance Literature Review Firm’s Performance

Managerial Sales
Compensation Statistical Methodologies Assets
Allowances and Operating Cash Flow
Perquisites Correlations Pre Tax Profit
Directors’ Fee Regression Analysis Selling and
Total Compensation for T-tests Administrative Expenses
the year F-test Profit as percentage of
R square significance for Sales
Correlations Return on Assets

Data for the Variables

Annual Reports of the
Firms
KSE website

Analysis and Results

Conclusion

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4 Analysis
The analysis is done with respect to each hypothesis. The results are discussed with reference to
the data used and conclusions are summarized. The analysis focuses on the data sets and
summary values from the MS Excel for the respective analysis.

4.1 CEO Compensation
The industry wide CEO compensation and breakup into base salary and variable bonuses is
shown in Figure I- CEO Compensation. The base salary and bonuses variates in the different
ranges across different industries and companies. The highest bonus based compensation is
paid to CEO of Bank of Punjab. We can also observe that compensation to CEO within industries
is different across the companies.

Figure I CEO Compensation

4.2 Directors Compensation
The director’s compensation is shown in Figure II, where the break up of compensation is
shown for Director’s Fee, Allowances and Perquisites and Managerial Compensation. Across the

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board, the Director’s Fee forms the lower portion of the compensation while allowances are an
indirect way of compensating the Director’s for their governance, forming major part of the
compensation.

Figure II Director’s Compensation

4.3 Executives Compensation
The Executive Compensation breakup is given in Figure III. Managerial Remuneration and
Allowances form equal parts of the compensation across the sample companies. Lucky Cement
pays highest allowances and perquisites to its executives. The large percentage of
compensation other than base salary indicates that variable compensation is used as a major
governance tool by the companies.

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Figure III Executive Compensation

4.4 Total Compensation
The total compensation trend in the sample of companies is shown in Figure IV. The log of
values is taken so that the variation across the companies can be standardized and easy for
analysis. The highest compensation is paid by Fauji Fertilizer Company.

Figure IV Total Compensation Paid by the Company

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5 H1 Compensation for Governance is related to the Firms’
Performance
The data of 22 companies in the 10 industries, was used to calculate the correlations among the
CEO Compensation, Directors Compensation, Executive Compensation and Total Compensation
of the firm with the Sales, Assets, Pre Tax Profit, Operating Cash Flows, Selling and
Administrative Expenses, Profit and percentage of Sales and Return on Assets. The Correlation
results in the Table V indicate many different facts which are explained as below.

Figure V Sample Summarized Correlation Values

Chief Executive Directors Executives
MR A&P Total Fee MR A&P Total MR A&P Total Total
Sales 0.57 0.54 0.63 0.03 0.20 0.18 0.20 0.53 0.20 0.51 0.54
Assets 0.57 -0.05 0.54 -0.06 0.04 -0.07 0.01 0.81 -0.09 0.66 0.67
Pre Tax Profit 0.55 0.21 0.56 0.18 0.26 0.08 0.22 0.75 0.04 0.65 0.67
Operating Cash 0.70 -0.02 0.66 0.02 0.00 -0.06 -0.01 0.83 0.05 0.72 0.73
flow
S&A Expenses 0.54 0.23 0.55 0.12 -0.01 -0.04 -0.02 0.59 0.38 0.62 0.63
Profit Margin 0.19 -0.08 0.17 -0.07 0.39 0.21 0.35 0.42 -0.09 0.33 0.34
Return on Assets 0.08 -0.04 0.07 -0.04 0.57 0.67 0.62 -0.06 -0.04 -0.06 -0.03
Log Data
Sales 0.28 0.39 0.34 0.13 0.10 0.09 0.10 0.31 0.19 0.32 0.33
Assets 0.38 0.27 0.41 0.07 0.11 0.02 0.10 0.55 0.07 0.48 0.49
Pre Tax Profit 0.38 0.32 0.42 0.13 0.35 0.24 0.33 0.49 0.13 0.46 0.48
Operating Cash 0.37 0.28 0.40 0.20 0.05 -0.01 0.04 0.67 0.37 0.68 0.67
flow
S & A Expenses 0.54 0.23 0.55 0.12 -0.01 -0.04 -0.02 0.59 0.38 0.62 0.63
Profit Margin 0.13 -0.05 0.12 0.00 0.31 0.20 0.29 0.24 -0.03 0.19 0.20
Return on Assets 0.06 0.09 0.08 0.09 0.35 0.33 0.36 0.03 0.12 0.06 0.08

The MR of CEO was correlated highest (0.70) to the Operating Cash Flows, followed by Sales
(0.57), Assets (0.57) and Pre Tax Profit 90.55). It has slightly positive correlation with Profit
Margin (0.19) and Return on Assets (0.08). On the contrary, the CEO Allowance and Perquisites
were correlated highest to Sales (0.54) and it was slightly negatively correlated to Operating

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Cash Flows (-0.02). It indicates that the basic salary of the CEO is dependant upon the Operating
Cash flows of the firm and they get performance bonus and variable compensation based upon
on the increase in sales. Similarly the total compensation the CEO is highly correlated to Sales
and Operating cash flows due to the breakup of the compensation paid to CEO.

The Director Fee is positively correlated to Pre Tax Profit (0.18) while the MR is highly
correlated to Return to Assets (0.57). Similarly A&P of Directors is also highly correlated to
Return on Assets (0.67). These correlations identify that Directors are the guardians of the
firms’ equity as well as liabilities as the best Corporate Governance advocates and as the return
on assets is increased, they are able to generate more value for the shareholders. Thus their
compensation is highly based on return on assets.

The Executives Compensation, similar to CEO, is highly correlated to Operating Cash Flow
(0.83), followed by Pre Tax Profit (0.75). The A&P of Executives are highly correlated to S&A
Expenses, which indicate the firms try to park the extra compensation for executives through
the S&A Accounts for tax purposes.

The Total Compensation is positively correlated to almost all the variables but it is highest with
Operating Cash Flows (0.73) followed by Pre Tax Profit and Assets (0.67). Thus, Operating Cash
flow forms one of the major indicators of the performance of the management of the firm.

To avoid the statistical errors in the correlations due to the magnitude of the values of
performance variables of the firm, log of the values is taken to minimize the error and identify
the correlations. It reduces the correlation value and removes the fluctuation impact of the
variable values. We can see from the Figure V, which the differences in correlations between
different variables are magnified and now ranking for the relationships among the variables can
be easily identified.

The CEO compensation is highly correlated to Pre tax Profit (0.42), closely followed by Assets
(0.41). It is marked difference from the earlier results of data without log values where the
compensation was highly correlated to Operating Cash Flow instead. The Directors

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Compensation is showing similar results that it is highly correlated to Return on Assets (0.33).
The Executive Compensation also shows same results where it is highest correlated to
Operating Cash Flow (0.68). The Total Compensation of the firm is highly correlated to
Operating Cash Flows (0.63).

Thus, the log of values of data helps us to identify the correlations more clearly and without
error caused due to the fluctuations in the high values of the variables.

5.1 Regression of Variables and Results
In all the regression analysis, the X axis variables are the Company Performance Variables and Y
axis variable are the Compensation Variables. All these regressions are run on the Total
Compensation in each category i.e. CEO, Directors and Executives and the Total Compensation
of the firm. The summary results are given below, for detailed tables see Appendix-Regression
Analysis. Table 1 summarizes the Regression statistics.

The Significant values of F are greater than 2.5, for T-stat significant values are above 1.64 and
for p value, the significant values are below 0.05 for 95 percent confidence. The closer the value
of R Square to 1, the higher is the significance of the correlation between the variables.

We can identify from the Table 1 results that CEO Compensation indicate that it has significant
model and variable relationship for Sales, Assets, Pre Tax Profit, Operating Cash Flows, S&A
Expenses , except for Profit as Percentage of Sales.

Directors Compensation is only significant with respect to model and variables for Pre Tax Profit
and Profit as Percentage of Sales.

The Executive Compensation and Total Compensation variables are significant for all
independent variables of performance i.e. Sales, Assets, Pre Tax Profit, Operating Cash Flows,
S&A Expenses and Profit as percentage of Sales.

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Table 1 Regression Summary Table
Variables R Square F T Stat P value
Chief Executive Officer Compensation
Sales 0.396569 56.51844 7.517875 4.94E-11
Assets 0.286792 34.58193 5.880641 7.61E-08
Pre Tax Profit 0.309645 38.57367 6.210771 1.81E-08
Operating Cash Flows 0.439192 67.35012 8.206712 2.02E-12
S&A Expenses 0.303797 37.52721 2.62E-08 0.005199
Profit as Percentage of Sales 0.027863 2.464864 1.569989 0.12009
Directors Compensation
Sales 0.041923 3.763182 1.939892 0.05567
Assets 0.000152 0.013065 0.114301 0.909265
Pre Tax Profit 0.049525 4.481054 2.11685 0.037161
Operating Cash Flows 0.000179 0.015436 -0.12424 0.901413
S&A Expenses 0.000347 0.02985 -0.17277 0.863237
Executives Compensation
Sales 0.255658 29.53829 5.434914 5.04E-07
Assets 0.435243 66.27786 8.141122 2.74E-12
Pre Tax Profit 0.421182 62.57869 7.910669 8.02E-12
S&A Expenses 0.378379 52.34793 7.235187 1.81E-10
Total Compensation
Sales 0.289336 35.01365 5.917233 6.5E-08
Assets 0.446537 69.38538 8.329789 1.14E-12
Pre Tax Profit 0.445395 69.06531 8.310554 1.24E-12
S&A Expenses 0.392416 55.54426 7.452802 6.67E-11

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6 H2 Different Industries follow different performance variables
for compensation
6.1 Industry Wise Correlation Analysis
The Industry Wise Correlation Analysis of relationships among cost of governance and firms’
profitability is done on the basis of results in the Figure XXX.

This table indicates that the industries follow different compensation policies in different
industries. Insurance Industry pays the CEO highest on Asset increase (0.97) and Sales (0.95),
while the Banking Industry pay the CEO on Sales (0.76) i.e. the Net Interest Income generated
by the bank. Cement Industry pays the CEO on Profit Margin (0.76), as this industry is
dependant upon the profit margin in the cost of goods sold and sale price. Fertilizer Industry
pays the CEO on the basis of Sales (0.73), while Chemicals industry pays on the basis of Assets
Increase (0.99). Automobile Industry pays the CEO on the basis of Operating Cash Flows
generated for the firm. FMCG Industry pays the CEO as per Pre Tax Profit (0.73). The Oil and
Gas Industry pays the CEO on the basis of gross revenue generated for the firm (0.49). The
Engineering industry pays on the basis of Pre Tax Profit (0.87).

The Director Compensation depicts the same fact that all companies compensate the directors
as per industry and business nature. Insurance industry pays the directors according to
Operating Cash Flows (0.54). The director fee is related to Pre Tax Profit (0.91) but other
compensation is paid with respect to operating cash flows. The banking industry pays the
directors with respect to Profit Margin (0.75), while Cement Industry pays the directors
according to Return on Assets (0.77). Chemical Industry pays the directors as per Sales increase
(0.96). Automobile industry pays the directors according to the Pre Tax Profit (0.61).Oil and Gas
Industry pays according to Sales (0.52) while engineering Industry pays according to Pre Tax
Profit (0.85).

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The Insurance, Banking and Cement Industries pay the executives according to Assets (0.98),
(0.93) and (0.60) respectively. The Fertilizer Industry pays according to Return on Assets (0.93)
and the Chemicals Industry pays according to Pre Tax Profit (0.86). The Automobile Industry
pays with respect to Profit Margin (0.47). The FMCG Industry pays according to the Sales (0.99)
as generated by executives of the firm. Oil and Gas Industry pays according to Profit Margin
(0.33) and Engineering Industry pays as per Pre Tax Profit (0.97).

The Total Compensation by the Insurance Industry, Chemicals Industry and Banking Industry as
cost of governance according to the Assets increase of the firm (0.98), (1.00) and (0.91)
respectively. The cement industry cost of compensation is dependant upon the Profit Margin
(0.55). The Fertilizer industry pays according to the Return on Assets (0.93). The Automobiles
Industry pays according to the Pre Tax Profit (0.49). The FMCG Industry pays according to the
Sales (1.00) while Oil and Gas Industry pays according to Profit Margin (0.33). The Engineering
Industry pays according to the Pre Tax Profit (0.96).

This analysis indicates that the industries which has a manufacturing concern pays the costs of
governance according to the margin based variables i.e. pre tax profit or Profit Margin. These
industries include the following

1. Cement Industry
2. Fertilizer Industry
3. Oil and Gas Industry
4. Engineering Industry
5. Automobile Industry

While the industries which have a service sector background or the manufacturing process is
shorter than one year use Sales or Assets increase as compensation policy. These industries
include the following

1. Insurance Industry
2. Banking Industry

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3. FMCG Industry
4. Chemicals Industry

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Figure VI Industry Wise Correlation Summary

Industry Variable Chief Executive Directors Executives Total

MR A&P Total Fee MR A&P Total MR A&P Total Total
Insur ance Sales 0.95 0.94 0.95 0.55 0.22 0.22 0.30 0.94 0.95 0.95 0.95
Insur ance Assets 0.96 0.97 0.97 0.77 0.12 0.12 0.24 0.99 0.96 0.98 0.98
Insur ance Pre Tax 0.90 0.93 0.92 0.91 -0.15 -0.15 -0.01 0.95 0.91 0.94 0.94
Profit
Insur ance Operating 0.47 0.40 0.45 -0.21 0.56 0.56 0.54 0.39 0.44 0.41 0.42
Cash flow
Insur ance S&A 0.49 0.41 0.46 -0.25 0.48 0.48 0.45 0.39 0.45 0.42 0.42
Expenses
Insur ance Profit -0.63 -0.60 -0.63 -0.28 -0.30 -0.30 -0.35 - -0.61 -0.62 -0.62
Margin 0.61
Insur ance Return on 0.89 0.88 0.90 0.78 -0.31 -0.31 -0.20 0.90 0.85 0.89 0.88
Assets

Bank Sales 0.76 -0.25 0.76 -0.15 0.08 -0.19 0.08 0.66 -0.26 0.66 0.68
Bank Assets 0.55 -0.45 0.55 -0.28 0.36 -0.35 0.36 0.93 -0.48 0.93 0.91
Bank Pre Tax 0.53 0.41 0.57 -0.38 0.40 0.31 0.39 0.25 0.22 0.25 0.45
Profit
Bank Operating 0.71 -0.34 0.71 -0.21 0.18 -0.27 0.18 0.88 -0.36 0.88 0.88
Cash flow
Bank S&A 0.74 -0.29 0.74 -0.18 0.06 -0.22 0.06 0.65 -0.30 0.65 0.67
Expenses
Bank Profit 0.08 -0.31 0.08 -0.19 0.75 -0.24 0.75 0.51 -0.33 0.51 0.48
Margin
Bank Return on -0.22 0.35 -0.22 -0.11 0.24 0.12 0.24 - 0.02 -0.35 -0.34
Assets 0.35

Cement Sales -0.14 0.94 -0.06 -0.32 -0.31 -0.26 -0.31 0.37 0.60 0.49 0.13
Cement Assets -0.16 0.99 -0.06 -0.33 -0.32 -0.27 -0.32 0.46 0.71 0.60 0.18
Cement Pre Tax 0.53 0.41 0.57 -0.38 0.40 0.31 0.39 0.25 0.22 0.25 0.45
Profit
Cement Operating -0.10 0.74 -0.03 -0.26 -0.25 -0.21 -0.25 0.10 0.24 0.17 -0.03
Cash flow
Cement S&A 0.42 -0.17 0.40 0.58 0.42 0.32 0.41 0.11 -0.06 0.04 0.30
Expenses
Cement Profit 0.76 -0.22 0.75 -0.22 0.74 0.66 0.76 0.14 -0.04 0.06 0.55
Margin
Cement Return on 0.75 -0.22 0.73 -0.21 0.72 0.78 0.77 0.10 -0.06 0.03 0.54
Assets

Fertilizer Sales 0.94 0.51 0.73 -0.35 - - -0.35 0.87 0.85 0.86 0.86

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Fertilizer Assets 0.51 -0.34 -0.03 -0.76 - - -0.76 0.76 0.79 0.78 0.78
Fertilizer Pre Tax 0.69 -0.13 0.19 -0.69 - - -0.69 0.88 0.90 0.89 0.89
Profit
Fertilizer Operating -0.71 -0.83 -0.86 -0.03 - - -0.03 - -0.39 -0.42 -0.42
Cash flow 0.44
Fertilizer S&A 0.82 0.46 0.65 -0.46 - - -0.46 0.73 0.71 0.72 0.72
Expenses
Fertilizer Profit -0.76 -0.87 -0.91 -0.09 - - -0.09 - -0.45 -0.47 -0.47
Margin 0.50
Fertilizer Return on 0.80 0.04 0.35 -0.62 - - -0.62 0.93 0.94 0.93 0.93
Assets

Chemicals Sales 0.87 0.84 0.87 - 0.98 0.87 0.96 0.36 0.96 0.71 0.78
Chemicals Assets 0.99 0.99 0.99 - 0.88 0.99 0.93 0.85 0.93 0.99 1.00
Chemicals Pre Tax 0.95 0.96 0.95 - 0.79 0.95 0.86 0.92 0.86 1.00 0.99
Profit
Chemicals Operating 0.98 1.00 0.98 - 0.87 0.98 0.92 0.81 0.92 0.97 0.98
Cash flow
Chemicals S&A 0.98 0.96 0.98 - 0.98 0.98 1.00 0.63 1.00 0.89 0.94
Expenses
Chemicals Profit 0.89 0.90 0.89 - 0.67 0.89 0.76 0.97 0.76 0.98 0.95
Margin
Chemicals Return on 0.92 0.92 0.92 - 0.72 0.92 0.80 0.95 0.80 0.99 0.97
Assets

Automobiles Sales -0.18 - -0.18 - 0.17 -0.35 -0.07 - -0.27 -0.26 -0.23
0.21
Automobiles Assets 0.33 - 0.33 - 0.72 0.00 0.49 0.35 0.17 0.32 0.37
Automobiles Pre Tax 0.45 - 0.45 - 0.83 0.09 0.61 0.45 0.27 0.44 0.49
Profit
Automobiles Operating 0.52 - 0.52 - 0.45 0.52 0.57 0.19 0.59 0.38 0.45
Cash flow
Automobiles S&A 0.41 - 0.41 - 0.74 0.05 0.52 0.54 0.19 0.47 0.50
Expenses
Automobiles Profit 0.43 - 0.43 - 0.54 0.26 0.50 0.44 0.35 0.47 0.49
Margin
Automobiles Return on 0.38 - 0.38 - 0.76 0.02 0.52 0.38 0.19 0.36 0.41
Assets

FMCG Sales 0.67 0.71 0.70 - - - - 0.99 0.99 0.99 0.99
FMCG Assets 0.51 0.62 0.60 - - - - 0.95 0.96 0.96 0.96
FMCG Pre Tax 0.73 0.74 0.74 - - - - 0.98 0.98 0.98 0.98
Profit
FMCG Operating 0.05 -0.04 -0.02 - - - - 0.57 0.45 0.52 0.52

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Cash flow

FMCG S&A 0.69 0.74 0.73 - - - - 0.99 1.00 1.00 1.00
Expenses
FMCG Profit -0.26 -0.37 -0.35 - - - - - -0.87 -0.90 -0.89
Margin 0.91
FMCG Return on 0.06 -0.12 -0.08 - - - - - -0.60 -0.62 -0.61
Assets 0.63

Oil and Gas Sales 0.56 0.03 0.49 0.52 - - 0.52 - -0.51 -0.59 -0.59
0.53
Oil and Gas Assets -0.29 0.81 0.11 0.24 - - 0.24 - 0.35 0.09 0.09
0.48
Oil and Gas Pre Tax -0.37 0.80 0.03 0.04 - - 0.04 - 0.34 0.12 0.13
Profit 0.38
Oil and Gas Operating -0.51 0.72 -0.12 0.05 - - 0.05 - 0.36 0.13 0.13
Cash flow 0.40
Oil and Gas S&A 0.59 -0.70 0.20 0.14 - - 0.14 0.13 -0.60 -0.42 -0.42
Expenses
Oil and Gas Profit -0.60 0.71 -0.20 0.01 - - 0.01 - 0.55 0.33 0.33
Margin 0.26
Oil and Gas Return on -0.46 0.76 -0.06 0.01 - - 0.01 - 0.41 0.19 0.19
Assets 0.35

Engineering Sales 0.70 0.69 0.69 0.59 0.62 0.85 0.69 0.95 0.96 0.95 0.90
Engineering Assets 0.75 0.80 0.78 0.73 0.73 0.92 0.79 0.84 0.79 0.84 0.84
Engineering Pre Tax 0.87 0.85 0.86 0.78 0.82 0.91 0.85 0.97 0.99 0.97 0.96
Profit
Engineering Operating -0.61 -0.63 -0.62 -0.72 -0.69 -0.37 -0.62 - -0.16 -0.18 -0.30
Cash flow 0.18
Engineering S&A 0.96 0.94 0.95 0.92 0.94 0.91 0.95 0.92 0.94 0.92 0.95
Expenses
Engineering Profit -0.19 -0.18 -0.18 -0.04 -0.09 -0.47 -0.18 - -0.64 -0.63 -0.52
Margin 0.63
Engineering Return on -0.32 -0.39 -0.36 -0.34 -0.32 -0.54 -0.38 - -0.33 -0.40 -0.40
Assets 0.41

Tobacco Sales -0.66 - -0.66 - -0.25 -0.52 -0.44 - -0.44 -0.30 -0.36
0.22
Tobacco Assets -0.88 - -0.88 - -0.14 -0.71 -0.48 - -0.48 -0.38 -0.45
0.32
Tobacco Pre Tax -0.68 - -0.68 - -0.21 -0.51 -0.41 - -0.41 -0.27 -0.34
Profit 0.19
Tobacco Operating -0.94 - -0.94 - 0.08 -0.71 -0.35 - -0.35 -0.29 -0.36
Cash flow 0.25
Tobacco S&A -0.64 - -0.64 - -0.17 -0.46 -0.36 - -0.36 -0.21 -0.28

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Profitability
Expenses 0.13

Tobacco Profit -0.57 - -0.57 - -0.08 -0.35 -0.24 - -0.24 -0.09 -0.16
Margin 0.01
Tobacco Return on -0.59 - -0.59 - -0.20 -0.42 -0.35 - -0.35 -0.20 -0.26
Assets 0.12

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Profitability

7 Conclusion
The findings from this research are focused on the cost of corporate governance (compensation
for governance) and the result of such costs in generating profit for firm, which is judged
through Firm’s Performance. The expectation was to find a significant relationship between
these two variables and identify the significant relationship among the cost of compensation
and firm’s performance variables. Both the hypothesis are accepted and null hypothesis i.e. no
significant relationship exists between cost of governance and firm’s profitability and different
industries pays differently and according to their own business cycles.

Every industry pays according to its own background and business nature. The relationship
between firms’ profitability and cost of compensation is highly significant and it proves that
firms pay according to the profitability of the organization. Thus, each stakeholder in the
compensation mechanism will be focusing on the ultimate goal of maximizing shareholders
value by increasing the profitability on year on year basis.

The compensation of CEO, Directors’, Executives and Total Compensation varies across the
industry and the relationship among the variables also differs. Executive compensation largely
consists of variable salary component i.e. bonuses and perquisites indicating the role of variable
compensation in governance mechanisms.

The basic salary of CEO is dependant upon operating cash flows and the variable compens ation
is dependant upon sales primarily. The compensation of Directors is highly correlated to Assets
which is indicates their guardianship towards the total assets i.e. liability claims as well as
equity claims.

CEO compensation relationships with Sales, Assets, Pre Tax Profit, Operating Cash Flows, S&A
Expenses are significant but not with Profit Margin and Return on Assets. Directors’
Compensation relationship with Sales, Assets, S&A Expenses and Operating Cash Flows is
insignificant but it is significant with Pre Tax Profit, Profit Margin and Return on Assets.

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Profitability
Executives Compensation and Total Compensation of the firm has significant relationship with
all performance variables.

The Industry based correlation analysis indicates that every industry follows its own norms of
business for compensation management. It also indicates that service sector industries pay
according to Sales and turnover performance variables while manufacturing based industries
compensate on the margin based performance variables.

This research identifies significant relationships between compensation variables and company
performance and paves way for further research in this regard in the corporate governance
arena of Pakistan.

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Profitability

8 Limitations
The limitations of the research are as following

The topic, itself is qualitative. Corporate Governance cannot be fairly analyzed through
companies’ annual reports or secondary data. Thus, the scores associated with CG
variables are up to the researcher, and may include a bias towards better ope rating
companies as judged by the researcher.
The sample size (less than 100 companies) and time period (5 years) will not capture all
the aspects of business cycle for many firms as well as it may not reflect true practices
of corporate governance keeping in view the infant stage of CG in Pakistan.
The study only focuses on the basic relationship of compensation with firm’s
performance. Further In-depth analysis of board structure impact on compensation, role
of CEO in compensation, role of committees in compensation management and areas
related to compensation need to be analyzed for fine details of the relationships among
the variables.

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Profitability

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Cost Of Governance Relationship With Firms Profitability

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