This paper investigates the relation between investor sentiment, executive compensation and corporate investment. We derive a model that shows the share price will be jointly affected by investor sentiment and the corporate investment decision. The model assumes that risk-averse investors hold heterogeneous beliefs about share prices. With a large number of uninformed but optimistic investors, and if a manager’s goal is to maximize her own compensation which has been provided exogenously by the firm, the model predicts that 1) under a compensation contract that includes both long-term options and long-term restricted shares or that includes only long-term options, and if the manager has some vested shares that can be sold, the manager over-invests and investment level increases with investors’ optimism, and 2) under these contracts, the relation between investment level and the weight on options (shares) depends on the value of parameters including investor sentiment and the weight on options (shares) . Using a large sample of US firms, we document the empirical relations that are consistent with our predictions.
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