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Earnings vs. stock-price based incentives in managerial compensation contracts

Author

Listed:
  • Antonio E. Bernardo

    (UCLA Anderson School of Management)

  • Hongbin Cai

    (Peking University)

  • Jiang Luo

    (Nanyang Technological University)

Abstract

We develop a theory of stock-price-based incentives even when the stock price does not contain information unknown to the firm. In our model, a manager must search for and decide on new investment projects when the market may have a difference of opinion about the quality of the firm’s investment opportunities. The firm optimally provides incentives based solely on realized earnings, leading to an efficient investment policy, when the market has congruent or pessimistic beliefs; however, the firm optimally introduces stock-price-based incentives, leading to an inefficient investment policy, when the market has optimistic beliefs. If the firm can raise equity capital on favorable terms, negative NPV projects from the perspective of the firm may be positive NPV projects from the perspective of current shareholders. The firm motivates the manager to take such projects by basing some compensation on the current stock price.

Suggested Citation

  • Antonio E. Bernardo & Hongbin Cai & Jiang Luo, 2016. "Earnings vs. stock-price based incentives in managerial compensation contracts," Review of Accounting Studies, Springer, vol. 21(1), pages 316-348, March.
  • Handle: RePEc:spr:reaccs:v:21:y:2016:i:1:d:10.1007_s11142-015-9339-6
    DOI: 10.1007/s11142-015-9339-6
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    Cited by:

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    2. Jiayu Huang & Yifan Wang & Yaojun Fan & Hexuan Li, 2022. "Gauging the effect of investor overconfidence on trading volume from the perspective of the relationship between lagged stock returns and current trading volume," International Finance, Wiley Blackwell, vol. 25(1), pages 103-123, April.

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    More about this item

    Keywords

    Compensation; Investment policy; Mispricing;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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