Effects of Management Compensation Schemes on Corporate Investment Decisions

This paper examines the effects of management compensation schemes on corporate investment decisions. This is a significant study because it helps to understand such a relationship and to design the optimal management compensation scheme which induces the manager to act towards the goals and best interests of the company. Assuming that compensation schemes consist of flat salary, bonus payment, and stock options, I first examine the effects of alternative compensation schemes on corporate investment decisions under all‐equity financing, then examine the issue in a setting where a firm relies on debt financing. I find that managers tend to underinvest when they have a higher shareholding and a larger profit sharing percentage. This result is independent of the level of debt financing. I also find that the underinvestment problem can be alleviated by increasing financial leverage. These results and findings provide testable hypothesis for future research. I expect a negative relationship between corporate performance and each of compensation scheme of management shareholdings, stock options and profit sharing percentage, but a positive relationship with financial leverage.