Executive Compensation and Company Valuation

Abstract

In the literature, the integration of the cash and risk effects of executive compensation into company valuation is discussed only marginally. This paper addresses the question of how these effects can be integrated into corporate valuation. Several methods for solving the problem are discussed and a method free of circular references, similar to the adjusted present value approach to company valuation, is identified. Contrary to a common assumption in the literature, there is no uniform and constant cost of capital for a company that uses employee stock options. Cost of capital needs to be adjusted to the cash and risk impact of equity‐based executive compensation. Making recourse to the treasury stock method, which is used to calculate diluted earnings per share, is not recommended here even though a corrected version of this method is used. I discuss different forms of equity‐based executive compensation, including the resulting allocation of risk and net present value between owners and managers.