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Form of Compensation and Managerial Decision Horizon

Published online by Cambridge University Press:  09 June 2010

M. P. Narayanan
M. P. Narayanan
Affiliation:
School of Business Administration, The University of Michigan, Ann Arbor, MI 48109–1234.
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 31 , Issue 4 , December 1996 , pp. 467 - 491
Copyright
Copyright © School of Business Administration, University of Washington 1996

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