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Chapter 2

Chapter 2. Executive Incentives. Chapter overview. Potential Managerial Temptations Types of Executive Compensation Does Incentive-based Compensation Work in General? Potential “Incentive” Problems with Incentive-based Compensation Other Compensation Crime and Punishment

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Chapter 2

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  1. Chapter2 Executive Incentives

  2. Chapter overview • Potential Managerial Temptations • Types of Executive Compensation • Does Incentive-based Compensation Work in General? • Potential “Incentive” Problems with Incentive-based Compensation • Other Compensation • Crime and Punishment • International Perspective-CEO Compensation Around the World

  3. Potential Managerial Temptations • A good manager should put the needs of other stakeholders before his own. • However, if shareholders cannot effectively monitor managers’ behavior, then managers may be tempted to put his needs first, even at the expenses of shareholders.

  4. Examples of Self-serving Managerial Actions • Shirking (i.e. not working hard) • Hiring friends • Consuming excessive perks • Building empires • Taking no risks or chances to avoid being fired • Having a short-run horizon if the managers is near retirement

  5. Types of Executive Compensation • Base Salary and Bonus • The base salary is usually determined through the benchmarking method. • At the end of every year,CEOs often receive cash bonuses whose size is computed based on the performance of the firm over the past year. • Comparison of awarding bonuses with giving large raises.

  6. Types of Executive Compensation (continued) • Stock Option • Executive stock options—the most common form of market-oriented incentive pay. • Stock options give the executive of the firm the incentive to manage the firm. • Stock options are believed to align managers’ goals with shareholders’ goals. • Stock options have asymmetric incentives

  7. Stock Option • Options and Accounting • Stock option’s favorable tax treatment for both the executive and the company • Accounting cost and economic cost • FAS 123(R)

  8. Types of Executive Compensation (continued) • Stock Grants • —An alternative form of long-term incentive compensation that avoids governance failure • Restricted stock does not have asymmetric incentives • Performance shares can be viewed as bonuses for past realized performance.

  9. Does Incentive-based Compensation Work in General? • Two ways to examine the efficacy of incentive-based compensation: • ex post evidence, pay-for-performance sensitivity • ex ante evidence

  10. Potential “Incentive” Problems with Incentive-based Compensation • Problems with Accounting-Based Incentives • Forego costly research and development that might be beneficial to the firm • Accounting profits may be manipulated • CEOs may place too much focus on manipulating short-term earnings

  11. Problems with Stock Option Incentives • CEOs might forego increasing dividends in favor of using the cash to try to increase the stock price • CEOs have a tendency to pick a higher risk business strategy • Stock options may be too far underwater to motivate the manager effectively • CEOs may try to do what they can to time stock price movements to match the time horizons of their stock options

  12. Another Problem with Executive Stock Options • Stock prices are affected by company performance but also by many other factors beyond its control • Repricing previously issued options may let options lose their effectiveness

  13. Real-World Examples • Disney CEO Michael Eisner —Stock options create the possibility that only short-term value will be created, not long-term value • Management’s Behavior at Xerox —Managers may manipulate accounting profits

  14. Example: Xerox Corporation

  15. Expensing Executive Options: An Easy Solution? • Expensing executive option—the cost of stock options issued to employees and executives should be treated as an expense on the granting firm’s financial statements. • Three reasons of expensing executive options: • To have better disclosure and account for the real cost of using options as compensation • To reduce the amount of options executives receive and reduce their total compensation • To reduce CEO’s incentive to time the market

  16. Other Compensation • Club membership, financial advisors, luxury cars and chauffeurs, personal travel, etc. • Retirement compensation • Company loan

  17. Crime and Punishment • An alternative way to solve the agency-problem is to increase the penalty • The new Sarbanes-Oxley Act

  18. International Perspective-CEO Compensation Around the World

  19. Summary • Stock and option incentives are believed to solve agency-problem • However, whether or not the incentives work results in much debate • If incentive compensation is imperfect, then monitors are needed.

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