Part 4: Human Capital

Question 1

Executive compensation

Answer 1

Short-term incentives - fixed pay (salary) & variable pay (bonus, profit-sharing)
Long-term incentives - fixed pay (defined benefit plans) & variable pay (stock options, defined contribution plans)

Question 2

Optimal contracting view

Answer 2

Aligning shareholder and managerial interest

Question 3

Limitations to optimal contracting

Answer 3

Compensation contracts discussed with board of directors, as for managers, there is no certainty they will seek shareholder value maximisation (little equity interest)

Question 4

Managerial power view

Answer 4

Limitations to optimal contracting indicate CEOs have substantial influence on compensation

Question 5

Power-pay relationships

Answer 5

Executive compensation is higher when

• Boards are weaker
• No large outside shareholder is present
• Institutional ownership is less concentrated
• Takeover defences are stronger

Question 6

Outrage

Answer 6

A package that leads to stakeholder outrage will be avoided by managers and directors

Question 7

Camouflage

Answer 7

Hiding compensation to avoid the outrage of shareholders

Question 8

Camouflage in practise

Answer 8

1. Compensation consultants - outside consultants often used in designing and communicating compensation packages. Incentives to justify compensation rather than optimizing
2. Stealth compensation - pay practises that make total compensation and pay-performance ratio more blurred (pension plans, deferred compensation, post-retirement perks, consulting contracts, executive loans)
3. Non-contracted goodbye payments

Question 9

Conclusions from lecture 12: agency, incentives, and managerial compensation

Answer 9

• With information asymmetry and misaligned incentives, agency costs occur
• Contracts are designed to align incentives
• Managerial power can undermine the optimal design of contracts
• Poor incentive structure can instead cause suboptimal managerial actions

Question 10

Reasons for equity compensation

Answer 10

1. Shareholder-management alignment
2. Scarcity of cash
3. Employee retention
4. Accounting and tax treatment
5. Rise of technology firms (?)

Question 11

Characteristics of employee stock option contracts

Answer 11

At-the-money 
Ten-year maturity 
Vesting periods  
Illiquid 
Forced exercise in mergers or exits

Question 12

Measurement issues when valuing employee stock options

Answer 12

• Vesting
• Illiquidity
• Which stock price? (we need the option value to estimate value per share, and the value per share to estimate option value)
• Taxation
• Non-trade firms

Question 13

Backdating

Answer 13

The practise of retroactively choosing the grant date of a stock option so that the date of the grant coincides with a date when the stock price was lower

Question 14

Narayanan et al. (2007)’s four consequences of backdating

Answer 14

1. Legal - backdating is illegal and have economic consequences for the firm
2. Tax - is treated differently between at-the-money options and in-the-money options
3. Disclosure - if done legally, require costly disclosures
4. Incentives - inefficient compensation

Question 15

How can we detect backdating?

Answer 15

Grant date occurring in a dip

Question 16

Suboptimal pay structures

Answer 16

Pay without performance
Option plans allowing for windfalls
At-the-money options
Freedom to unwinding equity incentives

Question 17

Examples of stealth compensation

Answer 17

Pension plans
Deferred compensation 
Post-retirement perks 
Consulting contracts
Executive loans 
Goodbye payments