How minimum shareholding restriction, early departure and vesting arrangements influence the valuation and incentive effects of performance stocks
Over the past decade, Australian companies have increased their use of performance stocks as a means of rewarding their executives. The prevalence of the use of performance stocks necessitates the correct valuation in order to properly reflect the cost to shareholders. We have adopted a constrained utility-based valuation approach developed by Ingersoll (2006) to value these instruments. This approach allows us to determine the executive's private value and the shareholder's objective value for these instruments. We find the private value is less than the objective value as executives face minimum shareholding constraints which means they are no longer optimally diversified. We also find this difference increases with the executive's exposure to the company stock price residual volatility. In terms of vesting arrangements upon early departure, we find altering these arrangements leads to the objective and private values changing by the same proportion. We conclude the cost-effectiveness of using performance stocks depends only on the company stock price residual volatility.
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