8 - Executive Compensation Flashcards
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
why are stock options usually granted at the money?
incentive for management to increase the stock price
what is the maximum amount of shares able to be issued to a CEO without causing dilution (i.e. maintaining the share price)?
○ = (NPV of cash flow OR retained profits) / (current share price)
○ to prove, (current amount of shares + new shares granted) × (current share price) = (current equity + NPV of cash flow OR retained profits)
why would shareholders want to issue stock options instead of straight shares? why do managers prefer stock options to shares?
it is less costly than issuing shares, plus shareholders want to issue minimum amount of shares so as not to destroy value, while still giving CEO incentive to accept positive NPV projects.
they lever up the return while reducing downside risk
what are the 4 key implications of stock vs options choice?
- delayed exercise mean CEO bared risk of option being out of the money
- when volatility increases, option worth more while share worth less
- CEO prefers option when volatility increase, prefers stock when it decreases.
- expect high risk firms (mining/hi-tech) reward CEOs with options
why would a CEO accept options in place of his/her regular salary? 2
- signal commitment, i.e. increase shareholders wealth by sacrificing benefits in exchange for options (incentive effect)
- if stock/option value certain of holding valuing, executives are indifferent (no incentive effect)
what does Yermack 1997 discuss?
options may not be as an effective compensation to align executive interests as thought
What does Yermack 1997 find? 2
- timing of awards coincide with favourable movements in company stock prices, i.e. CEOs receive stock option awards shortly before favourable news
- links between long-term incentive plans and changes in company performance:
- does motivate managers to make better decisions
- when executives have control over compensation will try to receive performance-based pay in advance of anticipated stock price rises i.e. apple
how do actual options differ from exec options? 7
- exces can exercise early
- exec options are not tradable
- execs can’t sell own stock
- execs are usually undiversified
- exec options usually have performance hurdle
- execs can affect volatility
- execs have insider knowledge
has the use of stock options increased or decreased as a means of compensation? why?
decreased, firms don’t value incentive benefits of options
