ABSTRACT
JENSEN AND MECKLING (1976) ILLUSTRATE that, to reduce agency conflicts with managers, shareholders are expected to tie managers’ wealth to firm, or stock price, performance. By using compensation policy to manage the slope of the relation between managers’ wealth and stock price, shareholders can induce managers to take actions that increase equity value. Managing this slope, however, is not sufficient to control agency conflicts arising between stockholders and managers. As is well-recognized in studies by Jensen and Meckling (1976), Haugen and Senbet (1981), and Smith and Stulz (1985), the convexity of the relation between stock price and managers’ wealth, in addition to the slope, must be managed to induce managers to make optimal investment and financing decisions.
