Managerial Incentives, Risk Aversion and Corporate Policy Decisions

Abstract

I examine the relationship between chief executive officer (CEO) incentives and the risk exposure generated through important corporate policy decisions: investment intensity, firm focus and leverage. Conditioning this relationship on how risk is expected to affect firm value, I show that the relationship is largely determined by the direction of the incentive effect. CEO delta encourages managers to adopt less risky corporate policy when such risk is not conducive to maximising firm value. However, when the goal of value-maximisation conflicts with the CEO’s propensity to avoid risk, I show that the incentive effect of delta at least partially offsets risk aversion. Delta encourages value-maximising investment and firm focus policy decisions, but may lead to less than optimal financing decisions; even in a sub-sample of under-levered firms, delta encourages managers to avoid debt. Controlling for the endogeneity of CEO incentives in a simultaneous equation setting, I provide strong evidence to suggest that causality flows in both directions: while CEO incentives do affect corporate policy, the firm’s optimal policy also influences the compensation contract. Collectively, these findings explain the wide variation in past studies of the delta-risk relationship, and provide new evidence that equity incentives can have perverse effects on firm value.