Stock-Based Compensation and CEO (Dis)Incentives / Efraim Benmelech, Eugene Kandel, Pietro Veronesi.

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Benmelech, Efraim

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w13732.Publication details: Cambridge, Mass. National Bureau of Economic Research 2008.Description: 1 online resource: illustrations (black and white)Subject(s):

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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.

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Previous	nber w1373 Stabilization Policies and the Information Content of Real Wages /	nber w13730 How Costly Is Hospital Quality? A Revealed-Preference Approach /	nber w13731 Trade, Production Sharing, and the International Transmission of Business Cycles /	nber w13732 Stock-Based Compensation and CEO (Dis)Incentives /	nber w13733 Federal Institutions and the Democratic Transition: Learning from South Africa /	nber w13734 Globalization and the Sustainability of Large Current Account Imbalances: Size Matters /	nber w13735 Federalism's Values and the Value of Federalism /	Next

January 2008.

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.