Lecture 10 - Contracting Flashcards
Discuss why are incentives in contracts necessary?
2 for, 2 against
For: Overcome moral hazard problem.
- Align incentives of principal and agent.
- Reduce agency costs
Against:
- Reputation effect: motivates manager to work hard.
- Appears to be no disciplinary effect.
How do we measure ‘effort’?
We want information about short and long run.
Degree of informativeness is dependent on:
- Precision: low degree of random error or noise (volatile)
- Sensitive: degree/rate at which it responds to changes in effort.
What are the 2 types of measures of effort?
- Net income
- Share price
How precise and sensitive is net income?
Is it more precise or sensitive?
What decision making horizon does it put the manager in?
Precision:
- Less subject to random measurement error
- HC based NI: Less noisy (not impacted by economic wide events)
- FV based NI: à less precise (bias and error), but can increase sensitivity by alleviating recognition lag. (e.g. intangibles (goodwill))
Sensitive:
- Not sensitive to manager effort
- Largely due to recognition lag
- E.g. R&D à non recognition
- Subject to earnings management.
Net income is more precise than sensitive.
Shorter horizon (short term payoffs) – i.e. cutting costs à increasing net income
How precise and sensitive is share price as a metric for managerial effort?
Is it more precise or sensitive?
What decision making horizon does it put the manager in?
Precision:
- Volatile: More exposed to economic wide event
- Reduced informativeness
- E.g. interest rate changes, noise traders (liquidity)
- But: less direct ability to earnings manage.
Sensitive:
- Share prices are sensitive à market will impound announcement of information ‘instantly’.
- E.g. R&D, advertising
Share price is more sensitive than historic cost net income.
Longer horizon (long term payoffs) – taking more risks, more R&D.
Renumeration Based Compensation:
3 types:
- Salary
- Short-term incentive bonus
- Cash bonus
- Long-term incentive plan
- Paid in employee stock options (ESOs)
What is the role of risk for managers in contracting?
Management must adopt some compensation:
Largely due to neither metric are perfect representations of manager’s effort.
How is final pay calculated?
Final pay = fixed salary + performance based (compensation risk)
Lower performance measure precision = higher compensation risk.
Role of compensation risk for managers?
Why is it important to control risk for mangers?
Lower precision à higher risk
Managers will become risk averse
- Demand higher pay
- High ex ante (projected) risk will cause:
- Risk averse (only undertake safe projects)
- Extensive hedging
- Shareholders don’t need hedging as they have diversified portfolios are not exposed to firm specific risk.
Hedging undermines shareholder wealth.
What is the goal regarding compensation risk?
Too little risk à shirk
Too much:
- Higher than required pay
- Risk aversion
- Hedging
Goal is to minimise compensation risk:
What are 5 ways to reduce compensation risk?
- Relative performance evaluation
- Use other firms as a benchmark
- Board and compensation committee
- ‘Bogey’ and ‘cap’ à max and min compensations
- Stock options reduce ‘downside risk’
- Incentive for risk taking (increase share price)
- Allow earnings management
Opportunity for increased informativeness
What is a golden parachute?
When they need to remove a company executive, is a large payment or financial compensation.
Discuss, are managers paid too much?
How to overcome the ‘Yes’?
Yes:
- ‘power hypothesis’ à weak corporate governance
- Results in high levels of pay
- Overcome
- Good corporate governance (substantial independence):
- E.g. full disclosure, have a committee
No:
Pay is a result of increase in demand for CEO effort or scare managerial talent.
