Week 5 slides Flashcards
Why do stock options incentive managers to engage in riskier projects?
Because of the asymmetric pay-off function. Only upward potential, but no downward risk. Riskier projects (same expected outcome, but more varied outcomes) increase stock price volatility. The negative outcomes do not affect the manager, since his options are already worth 0.
Why is there a difference in stock value from the perspective of shareholders and exectuvies?
Assumption of valuation models is diversification, but executives are stacked with stocks/options of one firm, this overstates their portfolio value.
Besides providing motivation, what other effect do equity incentive give manager?
Managers’ (equity) incentives do not only boost motivation but also increase propensity of managers to opportunistically manage earnings to increase their personal wealth. An example is disclosure of bad news before option grant to lower the strike price.
What role does the stock market play in incentivizing managers to commit EM?
The stock market reacts strongly to not meeting expectations (economically illogical). Managers have strong incentives to meet targets.
What is the view point from incentive and an alternative on equity incentives of rank-and-file employees
Rank-and-file employees own considerable part of equity
Incentive POV: stock price is very noisy (and not sensitive) to employee’s action choices
Alternative rationale: (1) increase retention of non-executive employees and (2) building psychological ownership with firm. BUT new employer might reimburse costs
What is dismissal the function of and what can increase this
Dismissal is the function of likelihood of dismissal and costs of job loss. Poor performance is associated with a higher likelihood of dismissal
What advantage does a severence agreement have for the firm and the manager?
Manager: protects manager of risk if it is a volatile firm
Firm: in a volatile firm managers are incentivized to focus on short-term performance. Severage agreement can incentive them to focus on long-term results (investments)
Poor performance can be an indication of what 2 things?
Lob ability managers (adverse selection): not just bad skills, but more fit with organization.
Low effort of the manager (moral hazard)
What are the two perspectives on dismissal
- Managerial ability explanation: managers differ in ability, poor performance sign of low ability (or bad luck). Performance increases with better manager (or reversal of bad luck)
- Scapegoat explanation: Managers all equal in ability, dismissal sustained credible threat for remaining employees.
Why do promotions work as an incentive?
Tournament theory
- Employees exert effort to get a better paid position where reward is associated with position is fixed and employes compete for those positions
- Part of return of promotion is also be able to compete for further promotions to even better paid positions
- Considering outside candidates will decrease promotion-based incentives
How do group-based incentives work?
Evaluate someone based on group performance. Facilitates use of mutual monitoring and peer pressure, but does have the free rider problem.
What are the 3 main criticisms of incentive compensation packages?
- Executives granted outrageous compensation packages (high of bonus)
- ”” compensation only loosely related to performance
- Executives just riding bull markets, while at the same time being insulated from bad luck (asymmetric pay off function between good luck and bad luck).
What are the 2 perspectives on executive compensation?
Efficient contracting: observed levels and composition of compensation reflects competitive equilibrium in the market for managerial talent, and incentives are structured to optimize firm value.
Managerial power (rent extraction): Both level and composition are not determined by competitive market forces but rather by powerful CEOs, often working through or influencing captive board members.
What is the definition of CG?
Set of mechanisms and processes that help ensure that companies are directed and managed to create value for their owners, while fulfilling responsibilities to other stakeholders.
What is the audit committee?
Oversight over firm’s financial reporting process, internal controls and independent auditors
