Working Paper: CEPR ID: DP6515
Authors: Effi Benmelech; Eugene Kandel; Pietro Veronesi
Abstract: 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.
Keywords: CEO compensation; suboptimal investments
JEL Codes: G31; G34; G35
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock-based compensation (M52) | increased managerial effort (M54) |
| stock-based compensation (M52) | concealment of bad news (G14) |
| increased managerial effort (M54) | optimal investments (G11) |
| concealment of bad news (G14) | suboptimal investment policies (G11) |
| firm-specific compensation package (M52) | better managerial behavior (M54) |
| firm-specific compensation package (M52) | optimal investments (G11) |
| stock-based compensation (M52) | value destruction through suboptimal investments (G11) |