8 - Executive Compensation

Question 1

what is the purpose of managerial compensation?

Answer 1

to align manager’s interest with shareholder’s

Question 2

what do shareholders want the firm to do?

Answer 2

maximise wealth

Question 3

What are managers interested in achieving other than maximising wealth? 5

Answer 3

• reduce risk (keep their job)
• career advancement: take on projects that benefit themselves
• reduce effort: will not suffer full losses
• empire building
• protect other stakeholders of firm (employees)

Question 4

what does JENSEN & MURPHY 1990 discuss?

Answer 4

executive compensation and agency theory

compensation policy is designed to give CEO incentive to make decisions that increase shareholder’s wealth, i.e. pay should be sensitive to the firm’s overall performance, adjusted for external factors not within the CEO’s control (eg. devaluation in currency)

Question 5

based on executive compensation what should the actual firm value be?

Answer 5

max firm value - bad NPV project taken on - good NPV projects not taken on

Question 6

what are sub-optimal investment decisions?

Answer 6

• Entrenchment: invest in areas where manager has expertise, resistance to takeovers
• Neg NPV projects to minimise risk
• low debt to reduce bankruptcy risk (loss of tax shield)
• Horizon problems: short sighted investments

Question 7

list 1 external control, 3 internal controls and 2 other mechanisms that align managers incentives

Answer 7

EX: market for corp control/ takeovers
IN: - manager compensation contracts
- board of directors (monitoring)
- concentrated ownership

OTHER: managerial reputation
Market monitoring

Question 8

how can agency costs be reduced? 2

Answer 8

• align incentives

- monitor (accounting/ corp governance)

Question 9

what are the 4 key principles for managerial compensation?

Answer 9

• measuring inputs vs measuring outputs
• design optimal incentive contract
• relative performance evaluation
• accounting vs stock based compensation

Question 10

how does compensation differ for the measurement of inputs vs measurement of outputs? what is compensation usually based on, input or output?

Answer 10

Inputs:
monitoring- rewarding manager for actions
measuring quality of inputs is costly

Outputs:
incentive compensation - rewarding manager for outcomes

Usually output: output = effort + luck

Question 11

what does the optimal incentive contract incorporate?

Answer 11

fixed compensation and compensation based on performance objectives.
just fixed wage= manager not putting in any effort
just performance= costly for shareholders due to risk

mix encourages manager to put in effort without taking excessive risk

Question 12

when should incentive pay be favoured? 4

Answer 12

• effort affects output a lot
• output has low sensitivity to risk outside on mgmt control
• manager is not risk adverse
• effort is not costly to manager

Question 13

why is it said that variable compensation is costly to firms?

Answer 13

managers are compensated for luck

Question 14

what benefits does management ownership have? disadvantages?

Answer 14

directly affected by costs and benefits of efforts - more likely to make the right decision

risk aversion, wealth constraints

Question 15

what is the formula for a simple incentive contract?

Answer 15

Wage = A + BX
A- fixed wage
B- bonus
X- performance measure

Question 16

what three components does executive compensation have to link compensation to performance?

Answer 16

• fixed salary
• compensation based on financial performance
• compensation based on stock price

Question 17

what is meant by relative performance evaluation? why is this a good way to determine compensation? what is a disadvantage?

Answer 17

comparing performance to movements of the overall market/industry, removes the risk outside of managers control

firms may compete too aggressively i.e. manager gets bonus for increased market share- might result in decreased profits.

Question 18

what are the benefits (3) and disadvantages (2) of using accounting measures to decide on compensation?

Answer 18

• easily available
• easy to understand
• managers can see their impacts
• backward looking
• accounting earnings are subject to manipulation

Question 19

what are the benefits (1) and disadvantages (2) of using equity-base pay measures to decide on compensation?

Answer 19

• shareholders interested in maximising share price
• share prices change for reasons outside managers control
• prices change based on expectation as well as outcomes

Question 20

what happens when an executive/manager owns a large portion of stock?

Answer 20

they start acting like shareholders

Question 21

what are restricted shares? what is their benefit? what is the downside of this benefit?

Answer 21

free shares that cannot be traded until a hurdle condition is satisfied.

expose managers to the downside risk of share - options don’t. however this means that managers bare downside risk if price falls (sometimes outside their control) while shareholders bare agency cost if managers are self interested

Question 22

why are the implications of stock ownership? 2

Answer 22

■ low business risk firms → low growth, high cash flows → compensation tends to be based on earnings or cash flow measures
■ high business risk firms → high growth, volatile (high variance) cash flows → compensation tends to be equity-based (as incentive for managers to accept risk → in order to grow)

Question 23

how do stock options encourage risk taking in investments?

Answer 23

they are riskier than the underlying stock

they lever up the return while reducing downside risk

Question 24

why do stock options have a deferred exercise?

Answer 24

align management time horizon to maintain long term growth

Question 25

why are stock options usually granted at the money?

Answer 25

incentive for management to increase the stock price

Question 26

what is the maximum amount of shares able to be issued to a CEO without causing dilution (i.e. maintaining the share price)?

Answer 26

○ = (NPV of cash flow OR retained profits) / (current share price) ○ to prove, (current amount of shares + new shares granted) × (current share price) = (current equity + NPV of cash flow OR retained profits)

Question 27

why would shareholders want to issue stock options instead of straight shares? why do managers prefer stock options to shares?

Answer 27

it is less costly than issuing shares, plus shareholders want to issue minimum amount of shares so as not to destroy value, while still giving CEO incentive to accept positive NPV projects. they lever up the return while reducing downside risk

Question 28

what are the 4 key implications of stock vs options choice?

Answer 28

- delayed exercise mean CEO bared risk of option being out of the money - when volatility increases, option worth more while share worth less - CEO prefers option when volatility increase, prefers stock when it decreases. - expect high risk firms (mining/hi-tech) reward CEOs with options

Question 29

why would a CEO accept options in place of his/her regular salary? 2

Answer 29

- signal commitment, i.e. increase shareholders wealth by sacrificing benefits in exchange for options (incentive effect) - if stock/option value certain of holding valuing, executives are indifferent (no incentive effect)

Question 30

what does Yermack 1997 discuss?

Answer 30

options may not be as an effective compensation to align executive interests as thought

Question 31

What does Yermack 1997 find? 2

Answer 31

1. timing of awards coincide with favourable movements in company stock prices, i.e. CEOs receive stock option awards shortly before favourable news 2. links between long-term incentive plans and changes in company performance: - does motivate managers to make better decisions - when executives have control over compensation will try to receive performance-based pay in advance of anticipated stock price rises i.e. apple

Question 32

how do actual options differ from exec options? 7

Answer 32

- exces can exercise early - exec options are not tradable - execs can't sell own stock - execs are usually undiversified - exec options usually have performance hurdle - execs can affect volatility - execs have insider knowledge

Question 33

has the use of stock options increased or decreased as a means of compensation? why?

Answer 33

decreased, firms don't value incentive benefits of options