*2.1. Equity-Based Incentive and Managerial Risk Preference*

There is a large and growing literature on executive compensation and its influence on managerial incentives, corporate financing, investment, and firm value (Peng and Roell 2014; Gormley et al. 2013; Bereskin and Cicero 2013; Liu and Mauer 2011; Billett et al. 2010; Coles et al. 2006; Carpenter 2000). Practically, an executive compensation package consists of the short-term and long-term components. The former mainly includes salary and bonus, whereas the latter refers to restricted stock grants, grants of stock options, long-term incentive payouts, and other compensation. Although the annual salary can be partially decided by the past performance, and the bonus component is based on various metrics of accounting information (i.e., return on assets, return on equity, sales growth or other according measures relative to the industry or competitors), these two components are not the primary solutions for the shareholders, intuitively, to maximize the their value since neither of them are directly linked to stock returns, which is presumably concerned most by shareholders. As Jensen and Murphy (1990) point out, the present value of current and future increases in salary and bonus represents a small fraction of total financial incentives. Meanwhile, under the framework of principal-agent theory, incentive contract is designed to reduce the agency conflicts between risk-neutral shareholders and risk-averse managers. For this reason, compensation packages containing long-term incentives, particularly equity-based instruments, attract more interests and explorations.

Unlike well-diversified shareholders, managers cannot diversify their human capital. As a result, they tend to forgo positive NPV but highly risky projects when their benefits from an increase in firm value are lower than their costs associated with greater firm risk. Equity-like compensation is viewed as a mechanism to reduce this underinvestment problem through aligning the interests of managers and shareholders (Jensen and Meckling 1976). Smith and Stulz (1985) and Guay (1999) also suggest that equity compensation motivates managers to overcome risk aversion and hence induce optimal risk-taking behaviors. In particular, Smith and Stulz (1985) show that the risk-related incentive problem can be controlled by rewarding managers with stock options or common stocks to structure their wealth as a convex function of firm value, therefore leading to risk-seeking managers.
