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Review of Accounting Studies

, Volume 21, Issue 1, pp 316–348 | Cite as

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

  • Antonio E. Bernardo
  • Hongbin Cai
  • Jiang Luo
Article
  • 1.4k Downloads

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 

JEL Classification

D86 G31 G32 

Notes

Acknowledgments

We thank Henry Friedman, Jack Hughes, Ivo Welch, two anonymous referees, and the editor for very helpful comments. All errors are ours.

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Copyright information

© Springer Science+Business Media New York 2015

Authors and Affiliations

  1. 1.UCLA Anderson School of ManagementLos AngelesUSA
  2. 2.Guanghua School of ManagementPeking UniversityBeijingChina
  3. 3.Nanyang Technological UniversitySingaporeSingapore

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