FORM OF COMPENSATION AND MANAGERIAL DECISION HORIZON

This paper investigates the relation between the form of compensation and the manager's decision horizon, It finds that while all-cash contr acts induce managers to underinvest in the long term, all-stock contra cts induce overinvestment in the long term. It shows that compensation contracts consisting of both cash and restricted stock can produce ef ficient investment, thereby providing a rationale for the existence of both cash and stock incentive schemes in executive compensation packa ges. This explains why the adoption of either type of incentive scheme results in a positive stock price reaction. In addition, the paper de rives the following testable hypotheses: i) the proportion of the stoc k compensation is decreasing in the precision of the manager's ability and increasing in the precision of the firm's cash flows; ii) firms c ompensate their managers with proportionately more stock in profitable years and proportionately more cash in leaner years; and iii) the gre ater the growth opportunities, the higher the proportion of stock comp ensation.