Performance-Based Compensation and Firm Value – Experimental Evidence

28 Pages Posted: 6 Jun 2012 Last revised: 21 Apr 2015

See all articles by Glenn Pfeiffer

Glenn Pfeiffer

Chapman University - The George L. Argyros School of Business & Economics

Timothy W. Shields

Chapman University - George L. Argyros School of Business & Economics; Chapman University - Economic Science Institute

Date Written: April 15, 2015

Abstract

We study equity price reactions to compensation contracting in experimental markets. Motivated by research reporting positive price reactions to adoption of performance-based compensation plans for executive managers, but postulating competing reasons as to why, we design an experiment that allows us to manipulate variables separately to examine the effect of adverse selection and moral hazard on equity prices. We find that managers select contracts based on their private information, sometimes differing from predicted choices, and that private information is conveyed to the market by the choice of compensation contract and is reflected in stock prices. We refer to this as the sorting effect. Additionally, we find that managers do not always exert costly effort in spite of favorable incentives to do so. The design also allows us to assess if the market rationally prices managers’ actual choices. We find market prices are consistent with the empirically observed manager choices. Our results imply that to properly assess the impact of a compensation plan on market prices, one should consider both the sorting as well as the incentive effects of compensation contracts, and that the market anticipates errors in managers’ choices.

Keywords: compensation, experimental markets, sorting, incentives

JEL Classification: C92, D82, G12, J33, M52

Suggested Citation

Pfeiffer, Glenn and Shields, Timothy W., Performance-Based Compensation and Firm Value – Experimental Evidence (April 15, 2015). Accounting Horizons, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2078579 or http://dx.doi.org/10.2139/ssrn.2078579

Glenn Pfeiffer

Chapman University - The George L. Argyros School of Business & Economics ( email )

One University Drive
Orange, CA 92866
United States

Timothy W. Shields (Contact Author)

Chapman University - George L. Argyros School of Business & Economics ( email )

One University Drive
Orange, CA 92866
United States
714.289.2092 (Phone)

HOME PAGE: http://sites.google.com/site/timothywshields/

Chapman University - Economic Science Institute ( email )

One University Dr.
Orange, CA 92866
United States

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