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Stock-Based Compensation and CEO (Dis)Incentives

  • Benmelech, Efraim
  • Kandel, Eugene
  • Veronesi, Pietro

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6515.

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Date of creation: Oct 2007
Date of revision:
Handle: RePEc:cpr:ceprdp:6515
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