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Theexistenceofanagencyprobleminacorporationduetotheseparationofownershipandcontrolhasbeenwidelystudiedinliteratures.Thispaperexaminestheeffectsofmanagementcompensationschemesoncorporateinvestmentdecisions.Thispaperissignificantbecauseithelpstounderstandtherelationshipbetweenthem.Thisunderstandingsallowthedesignofanoptimalmanagementcompensationschemetoinducethemanagertoacttowardsthegoalsandbestinterestsofthecompany.GrossmanandHart(1983)investigatetheprincipalagencyproblem.Sincetheactionsoftheagentareunobservableandthefirstbestcourseofactionscannotbeachieved,GrossmanandHartshowthatoptimalmanagementcompensationschemeshouldbeadoptedtoinducethemanagertochoosethesecondbestcourseofactions.Besidesmanagementcompensationschemes,othermeanstoalleviatetheagencyproblemsarealsoexplored.FamaandJensen(1983)suggesttwowaysforreducingtheagencyproblem:competitivemarketmechanismsanddirectcontractualprovisions.Manne(1965)arguesthatamarketmechanismsuchasthethreatofatakeoverprovidedbythemarketcanbeusedforcorporatecontrol.Ex-postsettlingupbythemanageriallabourmarketcanalsodisciplinemanagersandinducethemtopursuetheinterestsofshareholders.Fama(1980)showsthatifmanageriallabourmarketsfunctionproperly,andifthedeviationofthefirm'sactualperformancefromstockholders'optimumissettledupinmanagers'compensation,thentheagencycostwillbefullybornebytheagent(manager).ThetheoreticalargumentsofJensenandMeckling(1976)andHaugenandSenbet(1981),andempiricalevidenceofAmihudandLev(1981),WalkingandLong(1984),AgrawalandMandelker(1985),andBenston(1985),amongothers,suggestthatmanagers'holdingofcommonstockandstockoptionshaveanimportanteffectonmanagerialincentives.Forexample,Benstonfindsthatchangesinthevalueofmanagers'stockholdingsarelargerthantheirannualemploymentincome.AgrawalandMandelkerfindthatexecutivesecurityholdingshavearoleinreducingagencyproblems.Thisimpliesthattheshareholdingsandstockoptionsofthemanagersarelikelytoaffectthecorporateinvestmentdecisions.Atypicalmanagementschemeconsistsofflatsalary,bonuspaymentandstockoptions.However,thestudies,sofar,onlyprovidelinksbetweenthestockoptionsandcorporateinvestmentdecisions.Therearefewevidencesthatthecompensationschemesmayhaveimpactsonthecorporateinvestmentdecisions.Thispaperaimstoprovideatheoreticalframeworktostudytheeffectsofmanagementcompensationschemesonthecorporateinvestmentdecisions.Assumingthatthecompensationschemesconsistofflatsalary,bonuspayment,andstockoptions,Ifirstexaminetheeffectsofalternativecompensationschemesoncorporateinvestmentdecisionsunderall-equityfinancing.Secondly,Iexaminetheissueinasettingwhereafirmreliesondebtfinancing.Brieflyspeaking,thefindingsareconsistentwithAmihudandLev'sresults.Managerswhohavehighshareholdingsandrewardedbyintensiveprofitsharingratiotendtounderinvest.However,theunderinvestmentproblemcanbemitigatedbyincreasingthefinancialleverage.Theremainderofthispaperisorganisedasfollows.SectionIIpresentsthemodel.SectionHIdiscussesthemanagerialincentivesunderall-equityfinancing.SectionIVexaminesthemanagerialincentivesunderdebtfinancing.SectionVdiscussestheempiricalimplicationsandpresentstheconclusionsofthestudy.Iconsiderathree-datetwo-periodmodel.Attimet0,afirmisestablishedandgoespublic.Therearenowtwokindsofownersinthefirm,namely,thecontrollingshareholderandtheatomisticshareholders.Theproceedsfrominitialpublicofferingareinvestedinsomeriskyassetswhichgenerateanintermediateearnings,I,att,.Atthebeginning,thefirmalsodecidesitsfinancialstructure.Amanagerisalsohiredtooperatethefirmatthistime.Themanagerisentitledtoholdafractionofthefirm'scommonstocksandstockoptions,a(where0al),atthebeginningofthefirstperiod.Attimet,,thefirmreceivesintermediateearnings,denotedbyI,fromtheinitialasset.Atthesametime,anewprojectinvestmentisavailabletothefirm.Forsimplicity,themodelassumesthatthefirmneedsalltheintermediateearnings,I,toinvestinthenewproject.Iftheprojectisacceptedatt,,itproducesastochasticearningsYint2,suchthatY={I+X,I-X},withProb[Y=I+X]=pandProb[Y=I-X]=1-p,respectively.Theprobability,p,isauniformdensityfunctionwithanintervalrangedfrom0to1.Initially,themodelalsoassumesthatthenetearnings,X,islessthaninitialinvestment,I.Thisassumptionisreasonablesincemostoftheinvestmentcannotearnamorethan100%rateofreturn.Later,thisassumptionisrelaxedtoinvestigatetheeffectoftheextraordinarilyprofitableinvestmentontheresults.Forsimplicity,Itisalsoassumedthatthereisnotimevalueforthemoneyandnodividendwillbepaidbeforet2.Iftheprojectisrejectedatt,,theintermediateearnings,I,willbekeptinthefirmanditsvalueatt2willbeequaltoI.EffectsofManagementCompensationSchemesonCorporateInvestmentDecisionOverinvestmentversusUnderinvestmentAriskneutralinvestorshouldinvestinanewprojectifitgeneratesapositiexpectedpayoff.Ifthepayoffisnormallyorsymmetricallydistributed,tinvestorshouldinvestwhenevertheprobabilityofmakingapositiveearninggreaterthan0.5.Theminimumlevelofprobabilityformakinganinvestmenttheneutralinvestorisknownasthecut-offprobability.Theprojectwillgenerzeroexpectedpayoffatacut-offprobability.Iftheinvestorinvestsonlyintprojectswit