Paper #784

Title:

On the valuation and incentive effects of executive cash bonus contracts

Authors:

Lionel Martellini and Branko Urosevic

Date:

December 2003

Abstract:

Executive compensation packages are often valued in an inconsistent manner: while employee stock options (ESOs) are typically valued ex-ante, cash bonuses are valued ex-post. This renders the existing valuation models of employee compensation packages theoretically unsatisfactory and, potentially, empirically distortive. In this paper, we propose an option-based framework for ex-ante valuation of cash bonus contracts. After obtaining closed-form expressions for ex-ante values of several frequently used types of bonus contracts, we utilize them to explore the e¤ects that the shape of a bonus contract has on the executive’s attitude toward risk-taking. We, also, study pay-performance sensitivity of such contracts. We show that the terms of a bonus contract can dramatically impact both risk-taking behavior as well as pay-performance incentives. Several testable predictions are made, and venues of future research outlined.

Keywords:

Executive compensation, cash bonus, incentives, risk-taking behavior

JEL codes:

J33; G13

Area of Research:

Finance and Accounting

Published in:

Managerial Finance, Vol. 31, No. 7. (July 2005), pp. 27-53

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