Managerial compensation and the underinvestment problem

This paper studies the effect of managerial compensation terms on the well-known “underinvestment” incentive. We extend the Mauer and Ott (2000) real-option model of corporate expansion, and show that, when the manager maximizes the value of his compensation package (rather than equity value), the underinvestment problem can be substantially mitigated. Further, by designing an appropriate compensation contract, it is possible to eliminate the underinvestment incentive altogether. This managerial contract, consisting of fixed salary and equity ownership, is explicitly derived in the model. The equity ownership level is found to be an increasing function of the manager's fixed salary and the company's earnings growth rate, and a decreasing function of leverage ratio, earnings volatility, tax rate, bankruptcy costs, and the manager's severance pay at bankruptcy.