S2 - Agency problems, compensation & performance management Flashcards
Agency problems occur when:
Managers do not act in the shareholders interest
What are some drawbacks of only offering a fixed salary to a CEO?
- Reduced effort
- Risk aversion
- Entrenching investment
- Taking perks anyway
- Don’t close loss making business
Top management must ensure middle managers and employees have:
Incentives to find and invest in projects
Why wont letting top managers control investment decisions work?
- Too many projects to analyse
- Details are beyond view of executives
How can agency costs be reduced?
Monitoring a manager’s efforts
Drawbacks of monitoring can include:
- Costs
- Diminishing returns
Because monitoring is imperfect, compensation plans must be designed to:
Attract competent managers and give them the right incentives
The managers compensation package should encourage managers to maximise:
Shareholder’s wealth
Compensation should be based on:
- Input (manager effort)
- Output (incomes or value added)
How do capital markets monitor managers actions?
Price mechanism
What is a price mechanism?
When stock prices reflect performance of the firm
Compensation tied to stock prices reduce:
- Costs
- Need for monitoring
What are three types of stock price performance bonuses?
- Stock options
- Restricted stock
- Performance shares
What are stock options?
-Give managers the right to buy company shares at a fixed price
What is restricted stock?
Stock that must be retained for several years
What are performance shares?
Shares awarded only if the company meets a target
What is an imperfection of stock related compensation?
Stock price performance may depend on events outside of managers control
What is a good way to compensate lower level managers?
Accounting measures
What are advantages of accounting based compensation?
- Based on absolute performance rather than investors expectations
- Makes it possible to measure performance of junior or lower level performance
What are some problems with accounting compensation?
- Temptation to run up short term profits
- Accounting earnings can be biased
- Growth in earnings doesn’t mean shareholders are better off
What are two techniques for overcoming the problems in accounting measures of performance?
- Net ROI
- Economic value added
Net ROI and economic value added both judge whether:
The plants returns are higher than the cost of capital
Residual income/EVA =
Net pound return after deducting a charge for the costs of capital
Economic profit =
Capital invested multiplied by the spread between return on investment and the cost of capital
What are advantages of Economic value added?
- 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
What are two limitations of EVA?
- Difficult to judge who/what is at fault for low EVA (manager or external)
- EVA doesn’t measure present value
What is the formula for economic rate of return?
(Cash reciepts + change in price)/beginning price
What is the formula for economic income?
Cash flow + change in present value
Any reduction in present value represents:
Economic depreciation
What’s the formula for book value?
Original cost - book depreciation
What is a better representation of a firm’s performance?
Economic rate of return
