DP6515 Stock-Based Compensation and CEO (Dis)Incentives

Author(s):	Efraim Benmelech, Eugene Kandel, Pietro Veronesi
Publication Date:	October 2007
Keyword(s):	CEO compensation, Sub-optimal investments
JEL(s):	G31, G34, G35
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=6515

Stock-based compensation is the standard solution to agency problems between shareholders and managers. In a dynamic rational expectations equilibrium model with asymmetric information we show that although stock-based compensation causes managers to work harder, it also induces them to hide any worsening of the firm?s investment opportunities by following largely sub-optimal investment policies. This problem is especially severe for growth firms, whose stock prices then become overvalued while managers hide the bad news to shareholders. We find that a firm-specific compensation package based on both stock and earnings performance instead induces a combination of high effort, truth revelation and optimal investments. The model produces numerous predictions that are consistent with the empirical evidence.