Marketable Incentive Contracts and Endogenous Management Objectives
Posted: 6 Sep 1999
Date Written: August 1994
Most of the agency and signalling models in corporate finance rely on management objective functions that have some exogenous distortion. An important paper by Dybvig and Zender (1991) shows how firms' financial policies and capital structures are often irrelevant when management incentive contracts are optimally chosen. This paper analyzes a model where risk-neutral investors choose an optimal contract for the firm's risk-averse manager before committing their funds and before there is any informational asymmetry. The manager is then allowed to trade her claim on the firm on a competitive market with risk-neutral participants who know exactly when the manager is trading and correctly infer the effect the trade will have on the manager's future actions. Despite this lack of "noise traders", the manager will choose to fully unwind her position in the firm. Her subsequent actions will therefore be entirely determined by her private taste for leisure or her career concerns. This result justifies the use of capital structure and budgeting as costly tools to affect the firm's real decisions, as well as the use of unverifiable performance information in management incentive contracts.
JEL Classification: G3, G31
Suggested Citation: Suggested Citation