Agency costs, executive incentives and corporate financial decisions

This paper investigates the roles of executive incentive structures in creating and mitigating investment-related agency costs. A model is developed which shows that underinvestment and overpayment of dividends are always expected to prevail when managers are offered short-term incentives, while overinvestment and underpayment of dividends are likely to exist when managers are offered long-term incentives. Using a large sample of non-financial US-listed firms over the period 1992-2009, it is found that managers underinvest and overpay dividends when offered vested stocks, but overinvest and underpay dividends when offered option incentives. An increase in these incentives, however, mitigates these problems. The results also suggest that, if properly constructed, long-term incentives might be superior to short-term incentives, and should be used alone in designing the optimal incentive package under certain conditions.