Session Topic: ISSUES IN CORPORATE FINANCE Presiding: JOHN J. McCONNELL* Optimal Managerial Contracts and Equilibrium Security Prices DOUGLAS W. DIAMOND and ROBERT E. VERRECCHIA** I. Introduction RECENT DEVELOPMENTS IN ECONOMIC theory have focused attention on efficient methods for providing incentives within a corporation, especially to top management. Jensen-Meckling  have examined some implications of incentive (or agency) problems for corporate finance. In this paper we combine a simple model of security market equilibrium with that of an optimal managerial incentive contract, using results of Harris-Raviv [a] and Holmstrom . We provide a rationale for including security prices in the managerial incentive contracts of publicly held firms.In this model we also show that non-systematic, diversifiable risks will be considered in the capital budgeting decisions of a managerial firm operated in the interests of its stockholders. This is in contrast to the implication of the Arbitrage Pricing Theory (a similar result follows from the Capital Asset Pricing Model) which abstracts from incentive problems and suggests that only systematic risks ought to be considered. The optimal-contract model of the corporation takes the following view of the firm. Since decision makers within a firm are not sole owners of the business, but
The Journal of Finance – Wiley
Published: May 1, 1982
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