Firm Value and Managerial Incentives : A Stochastic Frontier Approach

We provide a direct estimate of the magnitude of agency costs in U.S. publicly-held firms. Using a sample of 1,307 firms in 1992-1997, we compute an explicit performance benchmark that compares a firm’s actual Tobin’s Q to the Q∗ of a hypothetical fully-efficient firm having the same inputs and characteristics as the original firm. The Q of the average sample firm is around 16% below its Q∗ , equivalent to a $1,432 million reduction in its potential market value. We relate the shortfall in value to the incentives provided to CEOs. Boards appear to grant CEOs too few shares and too many options which are insufficiently sensitive tofirm risk. Our results do not appear to be driven by endogeneity biases.