INVESTOR SENTIMENT,EXECUTIVE COMPENSATION, AND CORPORATE INVESTMENT

1. INVESTOR SENTIMENT,EXECUTIVE COMPENSATION, AND CORPORATE INVESTMENT Dr Hui (Michael) Li Department of Economics and Finance La Trobe University

2. Agenda • Contribution of the paper • Literature review • The model • The empirical test • Conclusion

3. Contribution of the paper • Theoretical contribution The paper develops a model that incorporates ownership structure, investor sentiment, and executive compensation into the investigation for corporate investment decisions.

4. Empirical contribution • The paper shows that when managerial compensation only includes options and vested shares, for the sample of CEOs, the investment level is significantly associated with the weight on options, and generally increases with the proxies for investor sentiment. • For the sample of all top executives, the investment level generally increases with the proxies for investor sentiment, but is not significantly associated with the options and shares. • when managerial compensation includes options, restricted shares and vested shares, for both the sample of CEOs and top executives, the investment level generally increases with the proxies for investor sentiment, but is not significantly associated with the executive compensation.

5. Literature review • SV: Shleifer and Vishny. PS: Polk and Sapienza. GHH: Gilchrist, Himmelberg, and Huberman. BSX: Bolton, Sheiken, and Xiong.

6. MSV: Morck, Shleifer, and Vishny. BRS: Blanchard, Rhee, and Summers. GY: Goyal and Yamada. CS: Chirinko and Schaler. BSW: Baker, Stein, and Wurgler. GHH: Gilchrist, Himmelberg, and Huberman. PS: Polk and Sapienza. • The more recent evidence supports the theory that mispricing affects investment.

7. BKS: Baysinger, Kosnik, and Turl. AS stands for Aggarwal and Samwick • Theoretical models and empirical evidence suggest that there is a significant relationship between executive compensation and corporate investment.

8. AM: Agrawal and Mandelker. DS: Dechow and Sloan. AS: Aggarwal and Samwick. DDR: Datta. Iskandar-Datta, and Raman. CAR is cumulative abnormal return, BHAR is buy-and-hold abnormal return

9. Entrepreneur/Manager invests and may sell her shares Time 0 Firm liquidated Time 1 The model

10. The informed investors’ belief about the project’s payoff The uninformed investors’ belief about the project’s payoff The uninformed investors’ belief about the project’s payoff

11. The firm can issue unlimited liability debt to finance the project. The total number of investors is N and the fraction of informed investor is  . For simplicity, the interest rate is assumed to be zero. Each investor has negative exponential utility with constant risk aversion. The supply of the shares is normalized to 1. Under these assumptions, one can solve for the optimal demand for the uninformed investor and informed investor respectively.

13. An example of the relation between investment level, the marginal production and the NPV of the project

14. Case1: A manager maximized current share price

15. Case 2: A manager maximizes her own compensation • Salary plus restricted shares with long maturity • Salary plus options with long maturity • Salary plus long-term options plus vested and non-vested shares

16. Salary plus vested shares plus non-vested restricted shares • Salary plus long-term options plus vested shares

17. The empirical test • The hypotheses • Hypothesis 1: If a manager’s compensation contract only includes options and the managers have vested shares, then the investment level can be increasing or decreasing with the weight on options (shares), and the investment level should increase with investor sentiment. • Hypothesis 2: If a manager’s compensation contract includes options and restricted shares and if the manager has vested shares, then the investment level can be increasing or decreasing with the weight on options (shares), and the investment level should increase with investor sentiment.

18. The empirical test • The mispricing proxies • Discretionary accruals • Share turnover ratio • Dispersion of analyst forecasts of earning per share • Past net equity issuance • Database includes Compustat, CRSP, IBES and Thompson Reuters. Time period is between 1992 and 2005.

19. Discretionary accruals is given by The dispersion of analyst forecast is given by Share’s turnover ratio is calculated as the average monthly ratio of shares traded to shares outstanding. Net equity issuance is the average of the current year’s net equity issuance and the past two years’ net equity issuance, scaled by last year’s net PPE.

23. Conclusion • Most of the coefficients for mispricing proxies are positive and significant, which is consistent with the hypotheses. • This result indicates that a manager seeks to pursue an investment strategy that recognizes investor sentiment. • It appears empirically that when CEOs are incentivized by an option-only contract, the investment level is significantly associated with options adjusted as a percentage of total shares outstanding. When the CEOs have a contract that includes both options and restricted shares, neither options nor restricted shares are significantly associated with the investment level. • The result suggests that managers make investment decisions that cater for investor sentiment, indicating that managers do seek to maximize shareholders’ wealth or at least the wealth of those shareholders planning on selling in the near future.