Essays on executive compensation and firm scope

This dissertation consists of three essays that study the design of an optimal incentive contract and investigate how the existence of the principal-agent conflict affects firms' decisions to diversify and the size of diversification discount. The inclusion of both profit-based and stock price-based components in executive compensation contracts is somewhat of a puzzle as these metrics are related: the stock price is nothing but the present value of expected future profits. The first essay (presented in chapter 2) provides an explanation for this puzzle. It argues that such contracts provide senior managers with the incentive to optimally allocate effort to both implementing previously devised strategies that provide current profits and to formulating new strategies that create shareholder value. The second essay investigates stock-based compensation in more detail. The model developed there provides an explanation for the widespread use of options in executive compensations even when restricted stocks are a more efficient way to provide the right incentives. The third essay analyses the effect of principal-agent conflict on firm scope. By looking at the agency problem in conglomerates I provide a possible explanation for the existing diversification discount, examine the reasons behind firms' decisions to diversify, and analyze the reasons that preclude firms from value-increasing divestitures. I argue that the agency cost in a conglomerate is positively related to the number of divisions with good investment opportunities. (Abstract shortened by UMI.)...