Working Paper: NBER ID: w13732
Authors: Efraim 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 over-valued 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: stock-based compensation; CEO incentives; agency problems; investment strategies
JEL Codes: D2; G34; J3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock-based compensation (M52) | managerial effort (D29) |
| stock-based compensation (M52) | concealment of negative information (D82) |
| concealment of negative information (D82) | suboptimal investment policies (G11) |
| stock-based compensation (M52) | suboptimal investment policies (G11) |
| firm-specific compensation package (M52) | high effort (D29) |
| firm-specific compensation package (M52) | truth revelation (A13) |
| firm-specific compensation package (M52) | optimal investments (G11) |
| CEO compensation tied to reported dividends (M12) | truth revelation (A13) |
| CEO compensation tied to reported dividends (M12) | optimal investment policy (G11) |
| large stock component in CEO compensation (M12) | suboptimal investment strategies (G11) |
| stock-based compensation (M52) | destruction of firm value (G33) |