Public report, private information, managerial compensation and effort allocation
Creators: name: Wu, Martin Guohai
Publisher: name: University of British Columbia
Year: 2009

description: The shareholder-management relationship of a publicly traded corporation is a classic agency relation. The conflict of interest arises because of the separation of ownership and control. The alignment of the goals of the firm’s owners and the goals of the managers has been the central focus of various theories. Many theories, including agency theory, are advanced to examine why firms choose the management compensation levels and structures they do and what effects these variables are likely to have in terms of providing proper managerial incentives. Empirical evidence indicates that accounting- and marketbased information signals are frequently used as managerial performance measures. The premise is that tying management compensation to firm performance helps align the goals of managers with the goals of the firm’s owners. However, prior agency research has ignored the impact of the investors’ endogenous private information acquisition on managerial incentives. Because endogenous informa tion acquisition influences the informativeness of the market price, it likely affects the compensation contracts written on stock price, and hence influences managerial incen tives. Since investors in financial markets endogenously tradeoff the cost and benefit of information to decide whether to acquire private information signals, careful examina tion of investors’ private information acquisition decision can enrich our understanding of management compensation arrangements. Our study focuses on this issue. We start with a one-period, general asymmetric in formation structure, single risky asset (the firm) model similar to Grossman and Stiglitz (AER 1980), and establish the rational market price in the presence of a public report about the firm. It is shown that more investors decide endogenously to acquire the costly The shareholder-management relationship of a publicly traded corporation is a classic agency relation. The conflict of interest arises because of the separation of ownership and control. The alignment of the goals of the firm’s owners and the goals of the managers has been the central focus of various theories. Many theories, including agency theory, are advanced to examine why firms choose the management compensation levels and structures they do and what effects these variables are likely to have in terms of providing proper managerial incentives. Empirical evidence indicates that accounting- and marketbased information signals are frequently used as managerial performance measures. The premise is that tying management compensation to firm performance helps align the goals of managers with the goals of the firm’s owners. However, prior agency research has ignored the impact of the investors’ endogenous private information acquisition on managerial incentives. Because endogenous informa tion acquisition influences the informativeness of the market price, it likely affects the compensation contracts written on stock price, and hence influences managerial incen tives. Since investors in financial markets endogenously tradeoff the cost and benefit of information to decide whether to acquire private information signals, careful examina tion of investors’ private information acquisition decision can enrich our understanding of management compensation arrangements. Our study focuses on this issue. We start with a one-period, general asymmetric in formation structure, single risky asset (the firm) model similar to Grossman and Stiglitz (AER 1980), and establish the rational market price in the presence of a public report about the firm. It is shown that more investors decide endogenously to acquire the costly private signal as the firm’s inherent uncertainty increases. The general formulation con sidered here permits identification of the key factors affecting various relations. Second, we examine the shareholder-management relation in a multi-task agency setting. The compensation contract is assumed to be based on two signals. It is shown that the Banker and Datar (JAR 1989) result that the relative weights on the signals equals the ratio of a measure of sensitivity times precision of those signals still holds with proper extension of the sensitivity measure. The extended sensitivity measure incorporates the signals’ congruity with the firm’s gross payoff (Feitham and Xie, AR 1994) and the first-best allocation of effort. A second performance measure can be used in the compensation contract to expand the implementable effort set. Third, we examine the relative use of the price and earnings in providing incentives. Our result suggests that the inclusion of accounting earnings facilitates the incentive alignment between the managers and share holders. Fourth, we derive comparative statics and discuss empirical implications. The relative weights on the public report and a filtered price are independent (dependent) of the firm’s inherent uncertainty if the private information acquisition decision is en dogenous (exogenous). The impact of an increase in the firm’s inherent uncertainty on the relative weights on the public report and the observed market price is reduced if information acquisition is endogenous instead of exogenous. Finally, we compare a stock ownership contract with an option contract. For any given level of implementable ef fort, an ownership contract always generates higher net surplus to the shareholders than does an option contract. Furthermore, the optimal ownership contract induces higher second-best effort level than does the optimal option contract.