“Optimal Principal-Agent Contracting with both Equity and Cash Incentives” by Gurupdesh Pandher
University of British Columbia
This paper extends the standard principal agent model so that the pay contract explicitly includes all three forms of compensation (salary, variable-cash, and equity) and the firm profit function incorporates both cashflows and firm value. Further, CEO effort differentially impacts both cashflows and firm value. We obtain closed-form expressions for optimal effort and equity and cash incentive and model analysis and numerical study provide a number of insights and predictions on how equity and cash incentives impact CEO effort, firm profits, and the dual risks borne by the CEO. For instance, we find that cash incentives will exceed equity incentives for most firms and the ratio of equity-to-cash incentives is positively related to cashflow uncertainty and the CEO's ability to impact firm value, while it is negatively related to uncertainty in firm value and the CEO's effort-cashflows sensitivity. The behavior of equity/cash incentives is also consistent with important empirical features of CEO pay (e.g. high/low growth firms, ‘bull markets') and our numerical results show that CEO effort and expected firm profits under the complete contract are higher than equity-only and cash-only contracts for most plausible ranges of risk aversion and CEO effort-value effectiveness. Model results on the strong complementarity of equity and cash incentives also suggest that pay regressions relating CEO pay to shareholder returns will tend to underestimate the total incentives present in the complete contract. This, along with the ability of executives to hedge equity exposure, further argues for designing and evaluating managerial contracts in a framework that explicitly includes both equity and variable-cash incentives. Moreover, our results suggests that, due to market incompleteness between internal cashflows-based performance measures (e.g. earnings, cashflows) and market stock prices, cash-based incentives should play an important role in optimal CEO contracts since this exposure is difficult to hedge.