Ch4 - Monetary Incentives

Question 1

Three views on CEO compensation

Answer 1

• Competitive Pay
• Rent extraction
• Tournament prize/superstar

Question 2

Def. Competitive Pay

Answer 2

• Compensation is determined by market forces
• Larger firms pay more because more talent is needed
• Correlation between market capitalisation & CEO pay

Question 3

Def. Rent extraction

Answer 3

• CEO can influence their pay
• Pay is not influenced by market forces
• Pay is through less transparent channels (e.g. stock options, pensions, deferred pay
  evidence: after regulations, CEO pay dropped

Question 4

Def. Tournament prize

Answer 4

Executive salaries incentivise people to compete for top positions. Difference between top & middle in terms of abilities is marginal

Question 5

Compensation packages for top execs

Answer 5

• Fixed Salary
• Short term annual bonuses (perf. based)
• Long-term incentives plans (LTIP) -> restricted shares employee stock options, performance shares
• Contributions to pension plans
• Severance payments (termination)
• Perquisites (perks)

Question 6

ESOPs

Answer 6

Employee Stock Option Plans

• maturity 1-7 years
• vesting 1-4 years

++ capital gain & not income (Tax)
++ ESOPS are/were tax-deductible

– backdating (setting best prices)
– spring loading (issued before good news)
– bullet dodging (linked to bad news)

Question 7

Optimal Contracting

Answer 7

-CEOs with greater wealth (less risk averse) -> more shares as this makes him more risky
- Competition should filter out random factors (market & industry returns, business cycles, and raw materials)

Question 8

CEO compensation vs performance

Answer 8

• Initially weak link between pay & performance
• Later, stronger link found when including stock options

Question 9

Other issues with performance based pay

Answer 9

• Perquisites: lower transparency, excessive spending (corp. jet)
• Executives pension: limited disclosure requirements
• Compensation for luck: e.g. industry performance, oil price -> well governed companies usually not an issue

Question 10

Unintended consequences of performance base pay

Answer 10

• Acquisition: CEO with restricted or unvested stock more likely to resist acquisition
• Risk shifting: The more stock the CEO has, the higher the risk is, he is willing to take
• Mgmt Entrenchment, the more stock, the higher his voting right
• Dividen: The more stock, less likely to pay dividends as it reduces market price

Question 11

Performance Sensitivity of Compensation
Three Empirical Measures

Answer 11

Delta measure = ∂C / ∂V (Jenter Murphy)

Equity-at-stake measure = ∂C / (∂V/V)

Elasticity measure = (∂C/C) / (∂V/V)

C: Wealth of CEO
V: Company Value