Investment Decisions and the Subjective Valuation of Incentive-Based Compensation

Abstract

I develop a partial equilibrium agency model in a real options framework to examine how a manager with nontransferable compensation makes investment decisions in a complete world. Contrary to conventional wisdom, I find that the compensation options cause the delay of investment because the self-interested manger wants to keep the high total volatility to increase the value of his compensation options, the compound options on investment options. This result is consistent with the conclusion by Carlson, Fisher, and Giammarino (2004) that the firm becomes less risky after investment. In addition, my results provide new insight into the relationship between ownership and firm performance. Specifically, I find that the undiversified fraction of the manager's wealth concavefies the investment threshold and the value of the investment option. My decomposition of investment and exercise thresholds suggests that the idiosyncratic volatility causes the manager's subjective value reduction and early exercise of stock options, while the total cash flow volatility increases the values of both the investment and compensation options. An alternative explanation for the early exercise of his compensation option, the option on the investment option, is that the manager wants to avoid the decline of the total volatility due to the investment.