Project Selection, Production, Uncertainty, and Incentives

Abstract

We model how a firm motivates a risk-averse CEO not only to exert productive effort but also to evaluate and to adopt new projects. Evaluation effort produces better information on risky projects, but the agent may reject a good project in order to avoid risk. Productive effort increases the mean of firm value but the agent faces uncertainty in his productivity due to the externality created by the new project. We examine the effect of uncertainty about the success of the new project on contract slope and convexity. The convexity in the contract protects the agent from uncertainty about the success of the new project, and the contract is more convex when uncertainty is greater. The contract slope encourages the agent to work on both tasks and to make the right project choice. We show conditions under which increases in uncertainty about the success of the new project cause increases in the contract slope. This positive relation between contract slope and uncertainty contrasts with the standard agency model's prediction of a decreasing relation. The features of the optimal contract are broadly consistent with prior empirical evidence on cross-sectional variation in CEO incentives. In addition our model suggests that there can be two groups of firms. The first group of firms has high uncertainty, and there is an increasing relation between risk and CEO incentives. The second group of firms has lower uncertainty, and there is the traditional decreasing relation between risk and CEO incentives.