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Y2 Financial economics > S2 - Agency problems, compensation & performance management > Flashcards

S2 - Agency problems, compensation & performance management Flashcards

1
Q

Agency problems occur when:

A

Managers do not act in the shareholders interest

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2
Q

What are some drawbacks of only offering a fixed salary to a CEO?

A
  • Reduced effort
  • Risk aversion
  • Entrenching investment
  • Taking perks anyway
  • Don’t close loss making business
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3
Q

Top management must ensure middle managers and employees have:

A

Incentives to find and invest in projects

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4
Q

Why wont letting top managers control investment decisions work?

A
  • Too many projects to analyse

- Details are beyond view of executives

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5
Q

How can agency costs be reduced?

A

Monitoring a manager’s efforts

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6
Q

Drawbacks of monitoring can include:

A
  • Costs

- Diminishing returns

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7
Q

Because monitoring is imperfect, compensation plans must be designed to:

A

Attract competent managers and give them the right incentives

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8
Q

The managers compensation package should encourage managers to maximise:

A

Shareholder’s wealth

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9
Q

Compensation should be based on:

A
  • Input (manager effort)

- Output (incomes or value added)

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10
Q

How do capital markets monitor managers actions?

A

Price mechanism

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11
Q

What is a price mechanism?

A

When stock prices reflect performance of the firm

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12
Q

Compensation tied to stock prices reduce:

A
  • Costs

- Need for monitoring

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13
Q

What are three types of stock price performance bonuses?

A
  • Stock options
  • Restricted stock
  • Performance shares
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14
Q

What are stock options?

A

-Give managers the right to buy company shares at a fixed price

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15
Q

What is restricted stock?

A

Stock that must be retained for several years

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16
Q

What are performance shares?

A

Shares awarded only if the company meets a target

17
Q

What is an imperfection of stock related compensation?

A

Stock price performance may depend on events outside of managers control

18
Q

What is a good way to compensate lower level managers?

A

Accounting measures

19
Q

What are advantages of accounting based compensation?

A
  • Based on absolute performance rather than investors expectations
  • Makes it possible to measure performance of junior or lower level performance
20
Q

What are some problems with accounting compensation?

A
  • Temptation to run up short term profits
  • Accounting earnings can be biased
  • Growth in earnings doesn’t mean shareholders are better off
21
Q

What are two techniques for overcoming the problems in accounting measures of performance?

A
  • Net ROI

- Economic value added

22
Q

Net ROI and economic value added both judge whether:

A

The plants returns are higher than the cost of capital

23
Q

Residual income/EVA =

A

Net pound return after deducting a charge for the costs of capital

24
Q

Economic profit =

A

Capital invested multiplied by the spread between return on investment and the cost of capital

25
Q

What are advantages of Economic value added?

A
  • Encourages focus on increasing value, not just earnings
  • Managers motivated to invest in projects earning more than cost
  • Leads to reduction in assets/capital employed
26
Q

What are two limitations of EVA?

A
  • Difficult to judge who/what is at fault for low EVA (manager or external)
  • EVA doesn’t measure present value
27
Q

What is the formula for economic rate of return?

A

(Cash reciepts + change in price)/beginning price

28
Q

What is the formula for economic income?

A

Cash flow + change in present value

29
Q

Any reduction in present value represents:

A

Economic depreciation

30
Q

What’s the formula for book value?

A

Original cost - book depreciation

31
Q

What is a better representation of a firm’s performance?

A

Economic rate of return

Y2 Financial economics (20 decks)

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