ABSTRACT Investment decisions tend to affect outcomes beyond the decision-maker’s tenure at the enterprise, and these outcomes, moreover, depend in part on the actions of the decision-maker’s successors. Separation between ownership and management, with hired managers compensated by accounting-based performance pay, solves the resulting incentive horizon problem. By contrast, the standard solution to “sell the firm to the agent” or the use of stock-based compensation creates incentives to invest inefficiently. Optimal managerial incentive pay may in fact show weak or even inverse correlation with stock price and cash flow. Even in enterprises managed by their owners, the prospect of implementing accounting-based incentive compensation and separating ownership from management in the future can induce efficient decision incentives at present. The separation of management from ownership must, however, coincide with the sale of the business to a new owner under an accounting-based earn-out agreement.

ABSTRACT To explain the empirically documented nonlinear, non-monotonic relationship between earnings and firm value, it suffices to assume that firms continually take profit-maximizing decisions in response to newly arriving investment opportunities. The real options embedded in these opportunities create hysteresis effects that lead to the well-known, but so far poorly understood, negative earnings-to-value relation among loss-making firms. Optionality also predicts the future growth component of firm value to be a decreasing function of earnings among highly profitable firms. More generally, the dynamic options model implies an earnings-to-value mapping that can be non-monotonic even over narrow earnings intervals. The commonly used linear earnings-response estimation may, therefore, be a poor approximation even locally. These phenomena arise because optionality makes past and future earnings the product of an unobservable flow of opportunities and decisions whose time dynamics cannot be described by direct linear past-to-future extrapolation.