Tuesday, March 25, 2008

The Incentive to 'Bet the Farm': CEO Compensation and Major Investments by Gavin Smith, Peter Swan

In prepping for my MBA 610 (Corporate Finance) class where we examine executive pay and how it impacts agency costs, I found this article by Gavin Smith and Peter Swan.

SSRN-The Incentive to 'Bet the Farm': CEO Compensation and Major Investments:

Swim and Swan look at firms that do major investments and those that do not. They find that the way the CEO is paid does influence the investment behavior of the firms.

From the abstract:
"CEO incentives with option-based asymmetric payoffs greatly increase the likelihood that a firm will increase risk by undertaking both major real investments and acquisitions. In contrast, equity-based incentives that induce upside and downside symmetric payoffs are associated with fewer major acquisitions and neither encourages nor discourages real investments. Fixed pay is associated with low likelihood of major investments and a poorer prognosis.
When option-incentivized CEOs use equity for funding real investment decisions they have the best combination of incentives and funding source"

Which is really cool. It may not be the most ground breaking paper I have ever seen, but it definitely is worth the read! (If nothing else, read the 8 page introduction! In fact, if you are in my class, you should definitely do so :) )

Cite: Smith, Gavin and Swan, Peter L., "The Incentive to 'Bet the Farm': CEO Compensation and Major Investments" (23 February, 2008). Available at SSRN: http://ssrn.com/abstract=1009323

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