Incentive Compensation and the Management
of the Firm
As explored in chapter 6, the executive’s incentive compensation arrangements strongly influence the risk posture that she chooses for the firm. In part, the move to incentive compensation, which took root in the early 1990s and persisted for 20 years, was aimed at increasing the risk level that CEOs choose. However, we saw that induced risk-taking behavior had some undesirable outcomes. For example, an elevated level of equity-based incentive compensation may encourage a manager to unfairly shift risk to bondholders. More striking, many observers assert that incentive compensation in financial institutions induced excessive risk-taking that helped cause the financial crisis of 2007–2009.
Against the general background of risk taking considered in chapter 6, this chapter focuses on the link between incentive compensation and how CEOs manage their firms in several key dimensions. The key wealth-creating decision that the CEO makes is the capital-budgeting decision, or choosing the investment portfolio that the firm will pursue. The CEO can increase the value of the firm by undertaking large-scale projects with a high expected rate of return relative to the riskiness that the investment commitment entails. To secure funds to carry out wealth-generating projects, the firm must issue a mix of debt and equity to constitute the firm’s capital structure. Thus the investment and financing decisions lie at the very heart of managing the firm and are the keys to successful corporate management. Setting an incentive compensation plan that encourages CEOs to make the best investment and financing decisions is a key element of overall corporate success, and this chapter explores the interaction between these decisions and the CEO’s incentive compensation.
Beyond the capital-budgeting and capital-structure decisions, incentive compensation is interrelated with other specific aspects of firm management: the firm’s dividend and share repurchase decisions; the willingness of a firm to be acquired and to take over other firms; whether and how to engage in