The Carrot: Executive Compensation, Risk-Taking and Innovation

Abstract

Managers of firms with excess cash tend to misuse it. We extend the Radner-Shepp- Shiryaev framework, to create an incentive mechanism (the ‘carrot’) to motivate managers to pay out the cash instead. The problem cannot be solved in closed- form, and we devise a numerical technique to solve it. We find two main counter intuitive results: First, our mechanism results in higher firm value, and the greatest value goes to firms that are mid-level in their innovation. Second, we find that our mechanism increases risk-taking and interestingly, this is optimal to firm value maximization.