Agency Conflicts, Managerial Compensation and Firm Variance Essay

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Journal Of Financial And Strategic Decisions
Volume 9 Number 3 Fall 1996

This paper presents a theoretical model of the agency conflict between managers and shareholders. The problem is examined in an expected-utility-maximization scenario in which the explicit cost of the agency conflict that arises between the manager and shareholders is derived. The model determines the effect of changes in firm variance on various compensation components. Development of this model depends upon the recognition that an individual firm’s propensity for variance is firm specific and that the manager has limited control over the risk of the firm’s future cash flows. The ability of the manager to affect the variance of the firm’s future cash flows is shown to be an important characteristic in the development of an effective incentive compensation package.

Compensation of chief executive officers (CEOs) both in terms of amount and composition has received an increasing amount of attention over the last few years. The arguments typically center around either the “exorbitant” pay levels or the compensation arrangements themselves. Jensen and Murphy (1990) suggest that the pay levels are not exorbitant and, if compared to the CEO pay levels of the 1930s, CEOs today may be underpaid. They argue that “how much” CEOs are paid is not that important; however, “how” they are paid is very important. Jensen and Murphy (1990) provide evidence that the link between pay and performance is relatively weak, thus the composition of the compensation package needs further attention. This study attempts to model how CEOs are paid and in doing so illustrates how incentives can influence the managerial decision making process particularly in terms of risk bearing.1 This model provides some insight into why the link between pay and performance is relatively weak why there appears to be a gap between the theory and practice of providing top-management incentives (Baker, Jensen, and Murphy (1988)). The recent literature2 on agency conflicts between managers and shareholders is characterized by studies that test whether the implementation of incentive compensation schemes mitigate the manager-shareholder conflict. While these studies present evidence that incentives do influence managerial decision-making, no dominant class of incentives has been found. This finding is consistent with evidence that suggests firms must compensate according to their particular characteristics.3 This study will consider incentive compensation in relation to the manager’s ability to increase the risk of future cash flows. In this context the relationship between compensation, risk taking, and managerial behavior can be evaluated. This study also provides a top management compensation corollary to Jensen and Meckling’s (1976) finding that fixed claimants seek to reduce volatility while residual claimants seek to increase volatility. By focusing on executive compensation this study contributes to the literature in two ways: 1) it provides an examination of the agency conflict between managers and shareholders in an expected-utility-maximization framework.; and 2) it provides testable propositions. Previous studies have evaluated how compensation influences management behavior (Agrawal and Mandelker (1987)). However, it is difficult to determine the true influence of incentive compensation due to the often high degree of information asymmetry between managers and shareholders. Because managers have private and often superior information about the expected value of future projects (Bizjak, Brickley, and Coles (1993)) and their
*Rutgers University



Journal Of Financial And Strategic Decisions

associated risks, it is difficult to observe management’s true effort. Lewellen, Loderer, and Martin (1987) predict that managers of growth firms will receive a larger proportion