On the Valuation and Incentive Effects of Executive Cash Bonus Contracts

29 Pages Posted: 8 Feb 2001

See all articles by Lionel Martellini

Lionel Martellini

EDHEC Business School

Branko Urosevic

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences

Date Written: January 30, 2001

Abstract

Executive compensation packages are often valued in an inconsistent manner: while employee stock options (ESOs) are typically valued ex-ante, i.e., before uncertainties are resolved, cash bonuses are valued ex-post, i.e., by discounting the realized cash grants. Such a lack of consistency can, potentially, distort empirical results. A related, yet mostly overlooked, problem is that when ex-post valuation is used pay-performance measures cannot be well defined. Consistent use of ex-ante valuation for all components of a compensation package would simultaneously resolve both of these problems and provide a natural framework for the analysis of agency problems.

In this paper, we perform ex-ante valuation of cash bonus contracts as if the executive's performance were measured by the company stock price, demonstrate how the shape of the bonus contract influences the executive's attitude toward risk, and study the pay-performance sensitivity of such contracts. We commence by demonstrating that a typical executive bonus contract with a linear incentive zone has a payoff structure equivalent to a portfolio of standard and binary European call options so that the ex-ante contract value is given by the linear combination of Black and Scholes call and binary call prices, with the strike prices at the boundary points of the incentive zone. Assuming that a risk neutral executive can choose the level of stock price volatility by selecting a set of projects at origination, we show that bonus contract terms can dramatically affect the executive's risk taking behavior and pay-performance incentives. Our results are extended to bonus contracts with non-linear incentive zones, and performance share contracts with vesting risk. Several testable predictions are made, and venues of future research outlined.

Suggested Citation

Martellini, Lionel and Urosevic, Branko, On the Valuation and Incentive Effects of Executive Cash Bonus Contracts (January 30, 2001). Available at SSRN: https://ssrn.com/abstract=259283 or http://dx.doi.org/10.2139/ssrn.259283

Lionel Martellini (Contact Author)

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Branko Urosevic

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
34-93-542-2590 (Phone)

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