The Incentive to 'Bet the Farm': CEO Compensation and Major Investments

Abstract

Using a matched sample of firms that do and do not undertake major investments we find that CEO incentives with option-based asymmetric payoffs greatly increase the likelihood that a firm will increase risk by undertaking both major real investments and acquisitions. In contrast, equity-based incentives that induce upside and downside symmetric payoffs are associated with fewer major acquisitions and neither encourages nor discourages real investments. Fixed pay is associated with low likelihood of major investments and a poorer prognosis. When option-incentivized CEOs use equity for funding real investment decisions they have the best combination of incentives and funding source.

Keywords: Acquisitions, Capital Expenditures, Incentives, Firm Performance, Risk

JEL Classification: G23, G32, G34, J33