Second, managers can affect the volatility of firm’s equity. Risk-averse managers who are compensated in traditional ways (salary, bonus and stock) have incentive to keep the volatility of the firm low when they hold a large fraction of their human capital and their financial wealth in the firm. Such managers have incentives to turn down risk-increasing, positive NPV projects if the negative effect on their expected utility of an increase in total firm risk is larger than the positive effect of an increase in firm value. Highly undiversified, risk-averse managers will require increases in firm value to compensate them for increases in systematic.
