Integrated Ownership and Managerial Incentives with Endogenous Project Risk
Review of Accounting Studies, Forthcoming
50 Pages Posted: 12 Feb 2018 Last revised: 23 Sep 2019
Date Written: March 24, 2017
Integrated ownership is often seen as a way to foster specific investments. However, even in integrated firms, managers invest to maximize their compensation, which is chiefly driven by divisional income. Thus it is not clear that integration has any effect on investments in a world of decentralized decision-making. Building on recent findings that efficiency-enhancing investments raise not only the expected value of a project but also its variance, we show that, under plausible conditions, integration calls for low-powered incentive contracts: the managers invest more as they are less exposed to the investment-related (endogenous) risk, and the principal of an integrated firm has more to gain from greater investment. On the other hand, integration may result in higher-powered incentives if the project is inherently very risky or if the project-specific input is personally costly to the managers (rather than a monetary investment). The qualitative takeaway remains, however, that the contract adjustments under integration mitigate any input distortions present under non-integration. We also allow for firmwide performance evaluation under integration and show that it may lead to larger input distortions, but those are outweighed by improved risk sharing.
Keywords: firm ownership, vertical integration, pay-performance sensitivity, investments, risk, firmwide performance evaluation
JEL Classification: M40, D23, D80, L22
Suggested Citation: Suggested Citation