Question 4 Exam [Managerial Compensation] Flashcards
What are the three main problems with exposing managers to risk (incentives)?
1) Managers may not respond to risk/incentives in the way that the theory suggests because of managerial risk perceptions.
2) The design of the incentive systems is difficult to perfect, and may lead to unexpected results.
3) Other restraints on managerial behaviour may make it unnecessary to expose managers to risk in any case.
Explain how managers may not respond to incentives the way the theory suggests becuase of their own risk perceptions
Managers too are prone to heuristics and biases.
e.g. using gut instinct may be good in ill-defined situations and make the manager ambitious
Whats the principal-agent problem?
How does the rational owner of the firm (principal) get a rational manager (agent) to expend greater effort to increase expected profits μ[π(e)] when this increased effort e decreases the utility of the manager u(Y, e)? (their income)
What are the three factors that cause the Principal-agent Problem?
1) Effort by managers is not observable by owners.
2) Profits can’t be broken down into managerial effort/skill or a random event/spike.
3) Expected profits can’t be known to the owner until risk is taken to get said expected profits.
Whats the usual solution to the principal-agent problem?
Design a good executive compensation scheme to provide an incentive for rational management to expend effort (or skill, or low consumption of perquisites) – so long as the agent does, in fact, have sufficient influence over firm performance
Whats the First-best solution to the principal-agent problem?
if there’s a link between managerial pay and the firm’s expected profits could be established, so that pay = some function of μ[π(e)].
This would allow the interests of the owners (who want more μ[π(e)]) and the managers (who want more pay) could be aligned – as both parties will then benefit from greater managerial effort without imposing any risk on managers.
Whats the Second-best solution to the principal-agent problem?
Making executive pay a function of random profits π, so that managerial pay is random too - this reduces the expected utility of risk averse managers.
This gives management an incentive to increase effort (because π will be increased on average) and therefore produces a higher expected profit for owners.
What are the three main types of executive compensation (incentives)?
- Profit-related pay
- Company stock
- Company stock options
What are the risk implications with profit-related pay?
lead to a decrease in short-run and long-run profits.
SR - Falsifiying financial docs.
LR - Avoiding any investment that may bring better returns in future e.g. R&D.
What are the risk-implications with Company stock?
Managers will manage the company more cautiously in order to reduce the volatility of their own share returns.
What are the risk implications with Company stock-options?
More risk might be taken than optimal for the actual shareholders (who actually own current stock in the company).
Manager doesnt currently own any stock hence no loss if share price goes down for them.
State some ‘normal’ (opposed to ‘rational’) behavioural models relating to managerial behaviour
1) Insensitivity to probalities - no attention given to low-probabilities hence not prepared for rare events
2) Decisions of manager depend on framing effects - e.g. reach a target increases risk taking, dangers of falling below dominated managers attention
3) Stock-options affecting decision making - If Market value below strike price then risk take, if above then risk averse.
4) Managerial conceit (illusion of control) - Lucky managers behave as if they have control over the random event.
What are ways that managerial behaviour is controlled?
1) Penalties in Managerial Labour Markets - hard to get a job if they are responsible for last company going bankrupt or something similiar.
2) Organisational design - risk management policies, Responsible target-setting
3) Managerial incentive schemes - Law Society, Insititute of Chartered Accoutnants hold professionals to ethics standards etc. can be penalty if falling below these.
What type of balance does executive compensation need?
Dynamic Balance -
Ability to have a compensation scheme that stops excessive risk-taking and being excessively risk-averse.
State a market-based and an accounting-based reference point
Market based: Stock options
Accounting based: Return on Assets
