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

See all articles by Tim Baldenius

Tim Baldenius

Columbia Buiness School

Beatrice Michaeli

University of California, Los Angeles (UCLA)

Date Written: March 24, 2017

Abstract

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

Baldenius, Tim and Michaeli, Beatrice, Integrated Ownership and Managerial Incentives with Endogenous Project Risk (March 24, 2017). Review of Accounting Studies, Forthcoming . Available at SSRN: https://ssrn.com/abstract=3118554 or http://dx.doi.org/10.2139/ssrn.3118554

Tim Baldenius

Columbia Buiness School ( email )

3022 Broadway
New York, NY 10027
United States

Beatrice Michaeli (Contact Author)

University of California, Los Angeles (UCLA) ( email )

D415 Anderson Complex
Los Angeles, CA 90095
United States

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