Form of Compensation and Managerial Decision Horizon

M. P. Narayanan

Journal of Financial and Quantitative Analysis, 1996, vol. 31, issue 4, 467-491

Abstract: This paper investigates the relation between the form of compensation and the manager's decision horizon. It finds that while all-cash contracts induce managers to underinvest in the long term, all-stock contracts induce overinvestment in the long term. It shows that compensation contracts consisting of both cash and restricted stock can produce efficient investment, thereby providing a rationale for the existence of both cash and stock incentive schemes in executive compensation packages. This explains why the adoption of either type of incentive scheme results in a positive stock price reaction. In addition, the paper derives the following testable hypotheses: i) the proportion of the stock compensation is decreasing in the precision of the manager's ability and increasing in the precision of the firm's cash flows; ii) firms compensate their managers with proportionately more stock in profitable years and proportionately more cash in leaner years; and iii) the greater the growth opportunities, the higher the proportion of stock compensation.

Date: 1996
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