Incentive Pay that Causes Inefficient Managerial Replacement
Abstractã€€ã€€ It is well known that granting incentive pay, such as stock-based compensation, to an agent mitigates the agency problem created by the unobservability of the agentÂ’s effort level. Using contract theory, this paper shows that stock options mitigate the moral hazard problem. However, they create another problem, namely, a misalignment of the interest between the principal and the Â…firm. SpeciÂ…cally, I consider an environment in which the principal can save her payments to the incumbent agent where the rational choice of the principal on whether to replace or retain the incumbent agent becomes an inefficient decision from the perspective of total fiÂ…rm value. The paper further examines both long- and short-term vested options may exhibit over-replacement of the incumbent agent, but only the short-term vested options may exhibit under-replacement, along the parametric range of control benefiÂ…t.
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Length: 43 pages
Date of creation: Jun 2013
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-07-05 (All new papers)
- NEP-CTA-2013-07-05 (Contract Theory & Applications)
- NEP-HRM-2013-07-05 (Human Capital & Human Resource Management)
- NEP-LMA-2013-07-05 (Labor Markets - Supply, Demand, & Wages)
- NEP-PPM-2013-07-05 (Project, Program & Portfolio Management)
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