Do top executives behave myopically?
Finance / 25 February, 2016
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Professor of Finance, Head of Finance Department
Zacharias Sautner is Professor of Finance and Head of the Finance Department at Frankfurt School of Finance & Management. His research was published in leading international journals such as the Journal of Finance, Review of Financial Studies, or Review of Finance. He teaches corporate finance, valuation, and corporate governance. He has won various awards for his research and teaching.

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When surveyed, the vast majority of top executives attest that they would cut or delay long-term investment projects to meet upcoming performance targets. In a new paper me and my coauthor Tomislav Ladika shows that a sharp decrease in managerial horizon, caused by the sudden elimination of stock option vesting periods, led to cuts in long-term corporate investment. Vesting periods are a crucial determinant of managerial incentive horizon because they usually are the only explicit mechanism preventing executives from unwinding their equity incentives in the short run. The reason is that unvested stock options cannot be exercised and also cannot be retained when executives depart their firms, but vested options can be exercised on short notice and are not forfeited upon departure. Therefore when vesting periods are short or nonexistent, managers can profit from undertaking actions that boost short-term firm performance, and they can also sell the bulk of their equity holdings or leave before the long-term costs of myopic decisions are realized.

To establish the effect of managerial incentive horizon on investment, we exploit accounting regulation FAS 123-R, adopted by the FASB in December 2004, which required firms for the first time to expense the fair value of stock option grants in financial statements. Prior to FAS 123-R, firms did not have to factor the cost of stock option compensation into their accounting earnings. Importantly, FAS 123-R also generated retroactive expenses for unvested options that were granted years before the standard’s adoption. However, FASB allowed firms to avoid an accounting charge on these previously granted options by accelerating them to fully vest before FAS 123-R’s compliance date. As a result, more than 700 firms eliminated option vesting periods. This generated accounting savings equal to 23% of net income on average, but also reduced executives’ incentive horizons by 80%.

We use firms’ decisions to accelerate option vesting to examine whether shortened incentive horizons led executives to cut long-term investment measures. Our primary measure of investment is total discretionary firm investment, defined as the sum of capital expenditures and R&D expenditures. Cutting these investment sources leads to an immediate increase in a firm’s earnings and free cash flows, which financial analysts and investors use to value firms. This can lead to short-term stock-price increases, which executives could profit from by exercising their newly vesting options. At the same time, capital and R&D expenditures typically yield benefits only years into the future, possibly beyond the horizon of myopic managers.

Our estimates show that option acceleration had a strong negative effect on corporate investment. We find that a one-standard deviation increase in the percentage of options accelerated caused firms to subsequently reduce total investment rates by 0.05 in the same year (or 41% of the investment variable’s pre-FAS 123-R mean). This corresponds to a $14 million decrease in investment for the median accelerating firm. These results indicate that option acceleration led executives to reduce long-term investment.

To corroborate that these cuts are consistent with theories of managerial myopia, we next document that executives at accelerating firms subsequently reduced their exposure to long-term firm value. First, accelerating firms’ CEOs increased option exercises three-fold after option acceleration and sold most of the resulting shares. Option acceleration therefore not only decreased executives’ incentive horizons, but also led them to unwind their equity incentives. Second, voluntary CEO turnover at accelerating firms increased from 6.9% to 11% after option acceleration. This is consistent with a larger number of CEOs voluntarily departing before the long-term costs of investment cuts materialized.