Target Difficulty and Corporate Risk Taking

This study empirically examines the relation between the difficulty level of CEOs’ internal performance targets and corporate risk taking. We predict a U-shaped relation between target difficulty and corporate risk taking such that firms exhibit higher risk taking when performance targets are very easy or very difficult and lower risk taking when target difficulty is medium. Using recently available data on performance targets in CEOs’ annual bonus plans in 2,493 firm-year observations, we find results consistent with our hypothesis. Our results are robust to alternative measures of target difficulty, alternative measures of risk taking, and alternative research specifications. Cross-sectional analyses reveal that the U-shaped relation between target difficulty and risk taking is more pronounced when CEOs have less equity incentives and are less powerful. We contribute to the target setting literature by providing the first archival evidence on the relation between target difficulty and corporate risk taking.