Managerial Compensation, Market Liquidity, and the Overinvestment Problem

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This paper investigates the relationship among a firm's managerial incentive scheme, the market liquidity of its shares, and its investment policy. It shows that the shareholders' concern about the effectiveness of stock-based compensation can lead to an overinvestment problem. However, unlike other explanations in the literature, our results are not caused by suboptimal incentive contracts, nor do they rely on the assumption that managers are empire-builders. Rather, overinvestment serves to induce information production by outside investors. By accepting positive as well as negative NPV projects, a firm effectively increases the market's uncertainty about its cash flow, which gives traders more incentives to become informed. The increased information flow into the market improves the informativeness of the stock price and, thus, enables shareholders to design more efficient managerial compensation contracts. Our analysis demonstrates that if investors are sufficiently risk averse, overinvestment is a more effective way to improve market monitoring than increasing market liquidity by floating more shares. It further shows that suboptimal investment decisions are more prevalent when the stock market is booming and that these distortions pose a systematic risk to investors that cannot simply be diversified away.