Academic journal article Journal of Business Strategies

Optimal CEO Incentive Contracts: A Prospect Theory Explanation

Academic journal article Journal of Business Strategies

Optimal CEO Incentive Contracts: A Prospect Theory Explanation

Article excerpt

ABSTRACT

This study examines the relationship between CEO incentive-based compensation and firm performance, based on the role of prospect theory in executive compensation. Our results indicate that moderate levels of performance-based CEO compensation are generally optimal. When an executive's total compensation package is based more on firm performance there is often a level of higher returns, but to a point of diminishing return. Our findings suggest that boards must clearly communicate with CEOs to determine the most appropriate levels of incentive-based compensation. Additional managerial and theoretical implications are offered, as well as avenues for future research.

INTRODUCTION

The proper structuring of executive compensation contracts has been the subject of much debate in the finance (Jensen & Meckling, 1976; Jensen & Murphy, 1990) and management literatures (Wright, Ferris, Sarin, & Awasthi, 1996; Sundaramurthy, Rhoades, & Rechner, 2005). This debate has largely been grounded in agency theory, which suggests that executives should be given equity stakes in their companies in order to properly align their interests with shareholders' interests. Thus, equity ownership is assumed to have a positive and direct effect on firm performance because aligning the risk preferences of executives and shareholders is the key to aligning their interests. The results, however, have been inconclusive. It is possible that the reliance on agency theory and the assumption of a positive linear relationship between ownership and performance has been the cause of confusion. Prospect theory (Kahneman & Tversky, 1979), however, may provide a better explanation for how individuals actually make decisions regarding a bundle of financial resources. Prospect theory is derived from offering individuals prospects (decision sets) with various payoffs and observing their decision making process and outcomes. Prospect theory is presented as an alternative to utility theory assumptions that serve as the foundation for agency theory. We believe the application of prospect theory can help explain that the ownership-performance relationship is actually nonlinear (concave).

The purpose of this study is to apply prospect theory to incentive-based CEO compensation in an attempt to clarify conflicting findings in this area. Specifically, this study examines the relationship between CEO incentive-based compensation and subsequent firm performance in a sample containing 18,540 CEO observations from 1992-2004.

LITERATURE REVIEW

Ownership--Risk Relationship

By properly structuring an incentive contract, firms can motivate corporate insiders to engage in additional corporate risk taking while developing growth opportunities (Jensen & Meckling, 1976; Jensen & Murphy, 1990). In order to more closely merge the interests of corporate insiders and shareholders, and thus reduce the potential for agency conflict, insiders have often been provided with an equity interest in firms. Typically, firms allow discounted stock purchase programs or grant stock options in an attempt to reduce agency conflict. The presumption underlying these programs has been that there is a positive relationship between insider equity ownership and corporate risk taking (Wright et ah, 1996). Eisenmann (2002) does find that CEOs given equity ownership are more risk-seeking while those with no ownership are risk-averse.

However, other studies have shown that this increase in risk-taking behaviors will eventually diminish at higher levels of equity ownership. Wright et al. (2007) find that at low to moderate values of managerial stock ownership, risk-increasing decisions predominate. However, at substantial executive equity values, risk-reducing decisions are motivated. Similarly, Wright et al. (1996) find a nonlinear (concave) relationship between insider equity ownership and firm risk-taking. …

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