The existence of an agency problem in a corporation due to the separation of ownership and control has been widely studied in literatures. This paper examines the effects of management compensation schemes on corporate investment decisions. This paper is significant because it helps to understand the relationship between them. This understandings allow the design of an optimal management compensation scheme to induce the manager to act towards the goals and best interests of the company. Grossman and Hart (1983) investigate the principal agency problem. Since the actions of the agent are unobservable and the first best course of actions can not be achieved, Grossman and Hart show that optimal management compensation scheme should be adopted to induce the manager to choose the second best course of actions. Besides management compensation schemes, other means to alleviate the agency problems are also explored. Fama and Jensen (1983) suggest two ways for reducing the agency problem: competitive market mechanisms and direct contractual provisions. Manne (1965) argues that a market mechanism such as the threat of a takeover provided by the market can be used for corporate control. "Ex-post settling up" by the managerial labour market can also discipline managers and induce them to pursue the interests of shareholders. Fama (1980) shows that if managerial labour markets function properly, and if the deviation of the firm's actual performance from stockholders' optimum is settled up in managers' compensation, then the agency cost will be fully borne by the agent (manager).

The theoretical arguments of Jensen and Meckling (1976) and Haugen and Senbet (1981), and empirical evidence of Amihud andLev (1981), Walking and Long (1984), Agrawal and Mandelker (1985), andBenston (1985), among others, suggest that managers' holding of common stock and stock options have an important effect on managerial incentives. For example, Benston finds that changes in the value of managers' stock holdings are larger than their annual employment income. Agrawal and Mandelker find that executive security holdings have a role in reducing agency problems. This implies that the share holdings and stock options of the managers are likely to affect the corporate investment decisions. A typical management scheme consists of flat salary, bonus payment and stock options. However, the studies, so far, only provide links between the stock options and corporate investment decisions. There are few evidences that the compensation schemes may have impacts on the corporate investment decisions. This paper aims to provide a theoretical framework to study the effects of management compensation schemes on the corporate investment decisions. Assuming that the compensation schemes consist of flat salary, bonus payment, and stock options, I first examine the effects of alternative compensation schemes on corporate investment decisions under all-equity financing. Secondly, I examine the issue in a setting where a firm relies on debt financing. Briefly speaking, the findings are consistent with Amihud and Lev's results. Managers who have high shareholdings and rewarded by intensive profit sharing ratio tend to underinvest.However, the underinvestment problem can be mitigated by increasing the financial leverage. The remainder of this paper is organised as follows. Section II presents the model. Section HI discusses the managerial incentives under all-equity financing. Section IV examines the managerial incentives under debt financing. Section V discusses the empirical implications and presents the conclusions of the study. I consider a three-date two-period model. At time t0, a firm is established and goes public. There are now two kinds of owners in the firm, namely, the controlling shareholder and the atomistic shareholders. The proceeds from initial public offering are invested in some risky assets which generate an intermediate earnings, I, at t,. At the beginning, the firm also decides its financial structure. A manager is also hired to operate the firm at this time. The manager is entitled to hold a fraction of the firm's common stocks and stock options, a (where 0first period. At time t,, the firm receives intermediate earnings, denoted by I, from the initial asset. At the same time, a new project investment is available to the firm. For simplicity, the model assumes that the firm needs all the intermediate earnings, I, to invest in the new project. If the project is accepted at t,, it produces a stochastic earnings Y in t2, such that Y={I+X, I-X}, with Prob[Y=I+X] = p and Prob[Y=I-X] = 1-p, respectively. The probability, p, is a uniform density function with an interval ranged from 0 to 1. Initially, the model also assumes that the net earnings, X, is less than initial investment, I. This assumption is reasonable since most of the investment can not earn a more than 100% rate of return. Later, this assumption is relaxed to investigate the effect of the extraordinarily profitable investment on the results. For simplicity, It is also assumed that there is no time value for the money and no dividend will be paid before t2. If the project is rejected at t,, the intermediate earnings, I, will be kept in the firm and its value at t2 will be equal to I. Effects of Management Compensation Schemes on Corporate Investment Decision Overinvestment versus Underinvestment A risk neutral investor should invest in a new project if it generates a positiexpected payoff. If the payoff is normally or symmetrically distributed, tinvestor should invest whenever the probability of making a positive earninggreater than 0.5. The minimum level of probability for making an investment the neutral investor is known as the cut-off probability. The project will generzero expected payoff at a cut-off probability. If the investor invests only in tprojects with the cut-off probability greater than 0.5, then the investor tendsinvest in the less risky projects and this is known as the underinvestment. Ifinvestor invests the projects with a cut-off probability less than 0.5, then tinvestor tends to invest in more risky projects and this is known as thoverinvestment. In the paper, it is assumed that the atomistic shareholders risk neutral, the manager and controlling shareholder are risk averse.