How Managerial Incentives Affect Investment Decision?

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A firm’s debt level is a determinant of how much the firm will invest in the future and it can be used to move the firm toward investing the appropriate amount. In general, however, capital structure cannot by itself induce managers to invest optimally.

Higher debt ratios will increase the threat of bankruptcy, increased debt can induce management to avoid policies they might personally prefer but which reduce firm value. While debt ratios will fall as insiders and institutions increase their stake in the company, managers are anxious to decrease debt ratios to reduce their personal risk, Insider and institutional ownership concentration may substitute for the disciplinary effect of debt.

Designing optimal incentive contracts

In general, well-designed compensation contracts minimize the extent to which managers can be penalized by factors outside their control. It is important to consider the CEO’s future compensation. Executives receive compensation from a number of sources. Part of their pay is fixed, part is contingent on corporate profits, and part is contingent on improvements in the stock price of their companies.

Pay-for-performance sensitivities

CEOs of small firms have much higher pay-for-performance sensitivities than the CEOs of large firms. This is not particularly surprising given the way Jensen and Murphy calculate pay-for-performance sensitivities. For example, suppose that the CEO of a $100 billion company such as IBM had a pay-for-performance sensitivity of 1 percent, meaning that he or she would receive an extra $10 in compensation for every $1,000 in value improvement. With such a compensation contract the CEO would be given a bonus of more than $100 million for increasing the value of the firm by just 10 percent. While a 1 percent pay-for-performance sensitivity is probably not feasible at a company as large as IBM, far larger sensitivities are often observed at much smaller companies. In addition, because the CEOs of growth companies generally have more discretion than the CEOs of more mature companies, a number of authors have argued that the compensation of growth company CEOs should be more closely tied to their companies’ performance. However, the empirical evidence on this is somewhat mixed

Executives working for companies with less volatile stock prices have higher pay-for-performance sensitivity than executives that work for companies with more volatile stock prices.

Performance-based compensation

Performance-based compensation contracts come in two distinct forms: stock-based compensation contracts, which include executive stock options and other contracts that provide an executive with a payoff tied directly to the firm’s share price, and earnings or cash flow-based compensation contracts, based on nonmarket variables like earnings, cash flow, and adjusted cash flow numbers such as Stern Stewart’s Economic Value Added (EVATM).

Stock-Based Compensation. The advantage of stock-based compensation is that it motivates the manager to improve stock prices, which is exactly what shareholders would like the manager to do. However, there also are disadvantages associated with stock-based compensation which lead us to believe that earnings or cash flow-based compensation might be preferred in many cases.

The first disadvantage of stock-based compensation is that stock prices change from day to day for reasons outside the control of top managers (for example, changes in interest rates). The second disadvantage is that stock prices move because of changes in expectations as well as realizations.

With stock-based compensation plans, managers are penalized when investors have favorable expectations and are helped when investors have unfavorable expectations.

Earnings-Based Compensation. The principal advantage of compensating managers on the basis of earnings and cash flows is that the numbers are generally available for the individual business units of a firm as well as for nontraded companies that cannot easily base compensation on an observable stock price. However, compensating managers based on earnings and cash flows also has its drawbacks. First, it is difficult to calculate the cash flow number that would be appropriate to use for evaluating performance. For example, one cannot simply base the executive’s compensation on total earnings or cash flows because this will provide an incentive to increase the scale of the corporation’s operations, even if doing so requires the firm to take on negative net present value projects. Hence, there is a need to adjust the cash flows for the amount