Risk, Managerial Effort, and Project Choice

David Hirshleifer and Yoon Suh

Journal of Financial Intermediation,  September 1992


In our model risk-neutral shareholders need to motivate a manager to select among projects with different risks, and to work hard in implementing the chosen project. Curvature of the manager’s compensation contract as a function of profit affects his attitude toward project risk. The optimal curvature depends on the trade-off between controlling project risk and motivating effort. The analysis predicts greater option-based compensation when there are desirable risky growth opportunities (proxied by Tobin’s q or R&D expenditures) and less option compensation when there are effective monitoring institutions (such as outside directors and bank lenders).

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