This paper investigates the benefit of equity-based compensation (EBC) to mitigate the level of agency problem on corporate diversification decisions. First, we find positive abnormal returns surrounding the announcements of 118 cases of diversifying projects during the period 1993-2001. This paper also finds that the diversification decisions of firms who have a lower level of EBC do not increase shareholder wealth, while those of higher EBC firms generate significantly positive abnormal returns. The multivariate tests provide consistent evidence that the announcement effects for lower EBC firms are lower than for higher EBC firms, after growth opportunities, operating performance and firm size are controlled for. Our additional test shows that low-EBC diversifying firms experience significant long run stock price underperformance. These findings support the view that the use of equity based compensation plans dilute an incentive for managers to make non-value maximizing diversification decisions.

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