Investment and CEO compensation under limited commitment

Hengjie Ai, Rui Li

Research output: Contribution to journalArticlepeer-review

20 Scopus citations

Abstract

We extend the neoclassical investment model (Hayashi, 1982) to allow for limited commitment on compensation contracts. We consider three types of limited commitment: (i) managers cannot commit to compensation contracts that provide lower continuation utility than their outside options; (ii) shareholders cannot commit to negative net present value (NPV) projects; (iii) both the managers and the shareholders cannot commit. We characterize the optimal contract under general convex adjustment cost functions and provide examples for which closed-form solutions can be obtained. We show that, as in the data, small firms invest more, grow faster, and have a higher Tobin's Q than large firms under the optimal contract. In addition, the pattern of the dependence of chief executive officer (CEO) compensation on past performance implied by our model is also consistent with empirical evidence.

Original languageEnglish (US)
Pages (from-to)452-472
Number of pages21
JournalJournal of Financial Economics
Volume116
Issue number3
DOIs
StatePublished - Jun 1 2015

Keywords

  • Dynamic contract.
  • Investment
  • Limited commitment.

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