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

Antonio E. Bernardo (), Hongbin Cai and Jiang Luo
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Antonio E. Bernardo: UCLA Anderson School of Management
Hongbin Cai: Peking University
Jiang Luo: Nanyang Technological University

Review of Accounting Studies, 2016, vol. 21, issue 1, No 9, 316-348

Abstract: 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.

Keywords: Compensation; Investment policy; Mispricing (search for similar items in EconPapers)
JEL-codes: D86 G31 G32 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s11142-015-9339-6

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