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Bratton, William --- "Agency Theory and Incentive Compensation" [2012] ELECD 603; in Thomas, S. Randall; Hill, G. Jennifer (eds), "Research Handbook on Executive Pay" (Edward Elgar Publishing, 2012)

Book Title: Research Handbook on Executive Pay

Editor(s): Thomas, S. Randall; Hill, G. Jennifer

Publisher: Edward Elgar Publishing

ISBN (hard cover): 9781849803960

Section: Chapter 5

Section Title: Agency Theory and Incentive Compensation

Author(s): Bratton, William

Number of pages: 20

Extract:

5 Agency theory and incentive compensation
William Bratton


1 INTRODUCTION

Oliver Hart shows that in an ideal (and taxless) world, first-best results can easily be
achieved with an all-common-stock capital structure and a simple incentive compensa-
tion system. Hart describes a simple two-period situation where the firm is founded at t
= 0 and liquidated at t = 2, with an intermediate decision respecting liquidation or con-
tinuance to be made at t = 1, along with a dividend payment. Hart would make the
compensation of the manager depend entirely on the dividend d. That is, incentive com-
pensation I should equal B(d1 + d2), where B is a proportion of the firm's total returns.
If the payment also covers liquidation proceeds, where I = B[d1 + (d2, L)], the manager
can be expected to make an optimal decision respecting liquidation at t = 1. If the
expected value of L at t = 1 is greater than the total returns expected at t = 2, the firm is
liquidated at t = 1 and no costly contracting designed to align the manager's incentives
with those of outside investors is necessary (Hart 1995: 146­48). The problem, in Hart's
conception, is that the bribe B required to align management incentives with those of
outside security holders is unfeasibly large. Accordingly, a complex capital structure must
be devised in order to align incentives in the direction of optimal investment and ensure
that an actor with the appropriate incentives controls the assets.
Unfortunately, ...