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.