Market reaction to long-term incentive plan adoption: Equity dilution as an explanatory variable

Abstract

Long-term incentive plans are instituted to motivate top corporate executives and align principal-agent interests. Among others, forms of long-term incentive compensation include cash and stock awards, stock options, performance shares, stock appreciation rights, phantom stock, and participating units. The general contention behind instituting these awards is that they increase long-term shareholder wealth. Preliminary studies by Brickley, Bhagat & Lease (1985) , and Tehranian & Waeglein (1985) , support this contention. However, Jones, 1980a , Jones, 1980b documents evidence to show that shareholder groups do not view the impact of all incentive plans favourably. This paper focuses on the market reaction to the adoption of long-term incentive plans that reward executives through stock options. Analysing from an event-study perspective, our results provide some evidence that beyond a point incentive effects are offset by effects of equity dilution through stock options and shareholder wealth is reduced. Hence, it appears that a blanket endorsement of all long-term incentive plans as being in the interest of shareholders is not warranted. This study adds to existing literature on principal-agent relationships, and shows that equity dilution can be used as a variable to assess market reaction to long-term incentive plan adoption.