8 - Executive Compensation Flashcards
(33 cards)
what is the purpose of managerial compensation?
to align manager’s interest with shareholder’s
what do shareholders want the firm to do?
maximise wealth
What are managers interested in achieving other than maximising wealth? 5
- reduce risk (keep their job)
- career advancement: take on projects that benefit themselves
- reduce effort: will not suffer full losses
- empire building
- protect other stakeholders of firm (employees)
what does JENSEN & MURPHY 1990 discuss?
executive compensation and agency theory
compensation policy is designed to give CEO incentive to make decisions that increase shareholder’s wealth, i.e. pay should be sensitive to the firm’s overall performance, adjusted for external factors not within the CEO’s control (eg. devaluation in currency)
based on executive compensation what should the actual firm value be?
max firm value - bad NPV project taken on - good NPV projects not taken on
what are sub-optimal investment decisions?
- Entrenchment: invest in areas where manager has expertise, resistance to takeovers
- Neg NPV projects to minimise risk
- low debt to reduce bankruptcy risk (loss of tax shield)
- Horizon problems: short sighted investments
list 1 external control, 3 internal controls and 2 other mechanisms that align managers incentives
EX: market for corp control/ takeovers
IN: - manager compensation contracts
- board of directors (monitoring)
- concentrated ownership
OTHER: managerial reputation
Market monitoring
how can agency costs be reduced? 2
- align incentives
- monitor (accounting/ corp governance)
what are the 4 key principles for managerial compensation?
- measuring inputs vs measuring outputs
- design optimal incentive contract
- relative performance evaluation
- accounting vs stock based compensation
how does compensation differ for the measurement of inputs vs measurement of outputs? what is compensation usually based on, input or output?
Inputs:
monitoring- rewarding manager for actions
measuring quality of inputs is costly
Outputs:
incentive compensation - rewarding manager for outcomes
Usually output: output = effort + luck
what does the optimal incentive contract incorporate?
fixed compensation and compensation based on performance objectives.
just fixed wage= manager not putting in any effort
just performance= costly for shareholders due to risk
mix encourages manager to put in effort without taking excessive risk
when should incentive pay be favoured? 4
- effort affects output a lot
- output has low sensitivity to risk outside on mgmt control
- manager is not risk adverse
- effort is not costly to manager
why is it said that variable compensation is costly to firms?
managers are compensated for luck
what benefits does management ownership have? disadvantages?
directly affected by costs and benefits of efforts - more likely to make the right decision
risk aversion, wealth constraints
what is the formula for a simple incentive contract?
Wage = A + BX
A- fixed wage
B- bonus
X- performance measure
what three components does executive compensation have to link compensation to performance?
- fixed salary
- compensation based on financial performance
- compensation based on stock price
what is meant by relative performance evaluation? why is this a good way to determine compensation? what is a disadvantage?
comparing performance to movements of the overall market/industry, removes the risk outside of managers control
firms may compete too aggressively i.e. manager gets bonus for increased market share- might result in decreased profits.
what are the benefits (3) and disadvantages (2) of using accounting measures to decide on compensation?
- easily available
- easy to understand
- managers can see their impacts
- backward looking
- accounting earnings are subject to manipulation
what are the benefits (1) and disadvantages (2) of using equity-base pay measures to decide on compensation?
- shareholders interested in maximising share price
- share prices change for reasons outside managers control
- prices change based on expectation as well as outcomes
what happens when an executive/manager owns a large portion of stock?
they start acting like shareholders
what are restricted shares? what is their benefit? what is the downside of this benefit?
free shares that cannot be traded until a hurdle condition is satisfied.
expose managers to the downside risk of share - options don’t. however this means that managers bare downside risk if price falls (sometimes outside their control) while shareholders bare agency cost if managers are self interested
why are the implications of stock ownership? 2
■ low business risk firms → low growth, high cash flows → compensation tends to be based on earnings or cash flow measures
■ high business risk firms → high growth, volatile (high variance) cash flows → compensation tends to be equity-based (as incentive for managers to accept risk → in order to grow)
how do stock options encourage risk taking in investments?
they are riskier than the underlying stock
they lever up the return while reducing downside risk
why do stock options have a deferred exercise?
align management time horizon to maintain long term growth
