Stock-Based Compensation and CEO (Dis)Incentives
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
Hebrew University of Jerusalem - Department of Economics; Centre for Economic Policy Research (CEPR)
University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. DP6515
Stock-based compensation is the standard solution to agency problems between shareholders and managers. In a dynamic rational expectations equilibrium model with asymmetric information we show that although stock-based compensation causes managers to work harder, it also induces them to hide any worsening of the firm's investment opportunities by following largely sub-optimal investment policies. This problem is especially severe for growth firms, whose stock prices then become overvalued while managers hide the bad news to shareholders. We find that a firm-specific compensation package based on both stock and earnings performance instead induces a combination of high effort, truth revelation and optimal investments. The model produces numerous predictions that are consistent with the empirical evidence.
Number of Pages in PDF File: 52
Keywords: CEO compensation, Sub-optimal investments
JEL Classification: G31, G34, G35working papers series
Date posted: June 5, 2008
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