Week 4 slides

Question 1

3 key choices when using result controls

Answer 1

• Which (combination of) PM to use?
• Which target to set on each PM (and how should the target be set)
• Which incentives should be linked to PM outcomes (and how strong should each incentive be)?

Question 2

What 3 things are very important for budgets?

Answer 2

• Budgets should be strongly linked with strategic and operational planning
• Budgeting should facilitate learning
• Budget deviations during the year prompt analysis

Question 3

To what is budget expecilitly related, and what problem is there?

Answer 3

Budget is explicitly linked to plans and goals, but budget is somewhat disconnected from these.

Question 4

What are the (dis)advantages of lower-level budget particiapation?

Answer 4

• Specialized knowledge, managers need lower-level information
• Build commitment towards budgeting process.
• Downside budgetary slack (if budget used for incentive compensation)

Question 5

Why do budgeted numbers and targets differ?

Answer 5

Budgets aim for realism while targets should be effort-inducing

Question 6

Which 3 information sources are used to set targets?

Answer 6

1. Past performance (good performance is bonus, but also higher target)
2. Peer performance (compared to other managers, do all not meet it or only you?)
3. Other sources (customer satisfaction)

Question 7

What is target ratcheting?

Answer 7

adjusting future targets based on current performance. Is current performance fully incorporated in next-period target revision?

Question 8

How do you determine the target difficulty?

Answer 8

By the percentage of managers who attain targets (this is the same question as how much the target should be adjusted)

Question 9

What are the advantages and disadvantages of target ratcheting?

Answer 9

Advantages:
1. Challenging targets may induce higher effort
2. Same performance is not rewarded multiple times

Disadvantage:
- strategic behavior (ratchet effect)
- LIkelihood retention decrease if targets unattainable.

Question 10

What is serial correlations in consecutive target deviations?

Answer 10

Looking if the same people meet their targets, look at data from multiple years.
Idea that deviations from targets in one period may affect future periods.

Goal: Model if achieving target is a predictor of achieving targets next period

Question 11

How can you make sure to avoid punishing managers for putting in high effort?

Answer 11

• Not only absolute, but also relative performance
• If BU stronger (weaker) than peer performance, can reflect exceptional (subpar) managerial performance

Question 12

What can highly achievable targets give to managers?

Answer 12

Can insulate managers against risk of unfavorable, unforeseen events (noise)

Question 13

What can favorable nonfinancial performance imply?

Answer 13

That next-period financial targets might be increased more.

Question 14

How do you make sure that managers are compensated for facing more challenging targets?

Answer 14

By offering a suitable reward for achieving the high targets

Question 15

What is the main purpose of RPE?

Answer 15

Filter out common noise, such that less risk is imposed on respective manager

Question 16

What is the main disadvantage of RPE?

Answer 16

Reduces incentives for cooperation as helping others implies increasing the benchmark against which you are evaluated.

Question 17

In what way can subjectivity reduce risk imposed on managers by external uncontrollable factors

Answer 17

Allows company to include other factors

Question 18

In what way can achievable targets (buffer) reduce risk imposed on managers by external uncontrollable factors

Answer 18

Giving slightly lower targets can make managers still meet their target if the market is tough.

Question 19

In what way can RPE reduce risk imposed on managers by external uncontrollable factors

Answer 19

By evaluation on relative performance to peers, you can award a manager that nearly missed target if the other managers missed their targets by more.

Question 20

What are the 3 functions of providing incentives?

Answer 20

1. Effort effect: before the fact incentive alignment such that subordinate makes decision in the best interest of the superior
2. Selection effect: confident, non-risk averse employees self-select towards jobs with high incentive pay
3. Retention effect: Forfeitable equity incentives impose a cost on leaving to the extent that new employer will not reimburse these costs.

Question 21

What does providing high-powered incentives imply?

Answer 21

Providing high-powered incentives implies firms strongly incentivizing effort towards the PM

Question 22

When are high-powered incentives most suitable?

Answer 22

If firms possess high quality PM, meaning high congruence and low noise

Question 23

What is the risk of strong incentives?

Answer 23

Much risk exposed on employees (high noise)
Actions not in firm’s best interest (low congruence), such as behavioral displacement and gamesmanship

Question 24

What are 3 determinants of incentive intensity?

Answer 24

• Hierarchical level of respective manager (+)
• Monitoring difficulty (+)
• Riskiness (-)

Question 25

On what 2 factors does the short vs long term orientation of incentives depend?

Answer 25

1. Is the PM forward-looking or backward looking?
2. Measurement date

Question 26

In what way is salary an incentive?

Answer 26

Level of salary does not fluctuate with performance and therefore does not provide incentives
Exception: efficiency wages
Salary increases reliant on performance give incentives (big impact since perpetuity).

Question 27

What is an annual bonus plan often classified as and what 3 basic components characterize it?

Answer 27

Often classified as short-term incentive
3 basic components:
1. PMs
2. Performance thresholds
3. Structure pay-performance relation (incentive intensity)

Question 28

In what way does bonus plans elicit non-congruent behavior?

Answer 28

Accounting manipulation (accruals) or real economic manipulation (altering pricing or investments)
- Postpone performance to next year if floor is out of reach
- Accelerate performance if close to incentive zone
- Postpone performance to next year if you exceed cap

Question 29

What is the downside of bonus plans

Answer 29

Come with a lot of strategic behavior. Plans have functions, but also come with gaming

Question 30

Do equity portfolios or grants lead to stronger incentives and how are they correlated?

Answer 30

Strongest incentive from portfolio
Grand and holding may be negatively correlated. Equity grants to compensate for achieved performance vs to rebalance euqity portfolio towards optimal levels

Question 31

How do performance shares work? Are they incentive or compensation?

Answer 31

Performance shares require you to first achieve targets, you then receive options/shares, but you need to hold these for a certain period. They work both as incentive and compensation

Question 32

What does Murphy conclude regarding interest alignment between executives and shareholders and why?

Answer 32

Alignment is weak because of low fractional ownership is too low. With Beta 0,006 a pet project of 10M will be undertaken if CEO values it more than 60k

Question 33

What is the alternative view to Murphy (or Jensen & Meckling)?

Answer 33

small pay-performance sensitivities can still provide strong
dollar (!) incentives to managers.
A small % of share ownership in large firms can still lead to significant amount the CEO can earn.

Question 34

What are 3 reasons to still have bonus plans even though equity incentives are much larger

Answer 34

1. Bonus plan contains more specification about what you expect CEO to do
2. In organizations KPIs must work together, there should be a relationship between them. You can increase alignment between different levels
3. Show commitment to outsiders. If you include ESG in bonus plan you show that you are actually taking it serious.