Corporate Governance

1. Corporate Governance By: 1. Kenneth A. Kim John R. Nofsinger And 2. A. C. Fernando

2. Executive Incentives 3rd Lecture

3. Executive Incentives • Lecture Outline • Briefly discussion on principle-agent or agency problem. • How manager can effect different stakeholders. • Examples of management self-serving activities • Types of executive compensations • There are advantages and disadvantages of bonuses and permanent increases to salary. • But the question is whether these incentives based compensation really work or not.

4. Executive Incentives • Corporations are separated in between • Owners ( Stockholders) • Controllers ( Officers and executives) • This is the main cause of emerging problems. • i.e. principal-agent problem or agency problem • So effective solution is required i.e. • Incentives ( in this chapter) • Monitoring • Incentives solution means; • Tying executives wealth to the wealth of share holders to share the same goal.

5. Executive Incentives Potential Managerial Temptations • Manager’s action can affect the following; • Investors and lenders • The firm’s customers and suppliers • The firm’s employees • And of course himself • Good manager always think for the stakeholders first-not in common practice.

6. Executive Incentives • Examples of self-serving managerial actions include; • Shirking ( not working hard) • Hiring friends • Consuming excessive perks • Building empires ( making the firm as much as possible, even though it may hurt the firm’s per share value) • Taking no risks or chances to avoid being fired; and • Having a short-run horizon if the manager is near retirement-very dangerous

7. Executive Incentives Types of Executive Compensation • Company executives are compensated through different ways 1. Base Salary and Bonus • The CEO salary is determined through the benchmarking method-surveying the peers CEO salaries for compensation. • CEO salary has drifted upward, getting nice raises-competitive edge.

8. Executive Incentives • New CEOs making more than current CEOs. • Basic pay depends upon the characteristics of the firm, rather than the characteristics of the CEO. • So, large firm CEO will get more than small firm CEO. • Small firm can’t afford large firm CEO and vice versa.

9. Executive Incentives

10. Executive Incentives • Cash bonuses depends upon the firm’s previous year’s performance. • Based on; • Earning per share • Net Income-Dividend on Preferred Stock Average Outstanding Shares • Earnings before interest and taxes • Operational Revenue – Operating Expenses + Non Operating Income • Economic Value Added • Earnings – Cost of Capital

11. Executive Incentives • An advantage of awarding bonuses, as opposed to giving large raises, is that bonuses are one-time rewards for past realised performances, while raises are permanent additions to salaries for future unrealised performances. • Average bonus payments for CEOs in large firm was $1.5 million in 2004.

12. Executive Incentives • Advantages of Bonus • Appreciation for past performance • Motivation for future goals • Focus on quality • Focus on individual output • Bring innovation and creativity • Disadvantages of Bonus • Costly for company • Taxes from employees • Fairness and Jealousy Issues

13. Executive Incentives • Advantages of Permanent Addition to salary • Brings loyalty to organization. • No fairness and Jealousy issues • Increase is not on the basis of past performance- it’s a routine work of organization for employees. • Disadvantages • Discourage innovation and creativity • No past performance appreciation.

14. Executive Incentives 2. Stock Options • The most common form of market-oriented incentive pay • It allows the executives to buy shares of stock at a fixed price, called the exercise or the strike price. • The executives can get benefits from the differences of prices i.e. Market price of the stock minus strike price.

15. Executive Incentives • That’s how you can align manager’s goal with shareholder’s goals. • This alignment will, somehow, overcome the problem with the separation of ownership and control. • The most common length of the options contract is 10 years. • The median option-based award realized for CEOs in large firms was $2.7 million in 2004.

16. Executive Incentives • 2.1. Options and Accounting • Stock option is a cost for company, if there is a difference between strike price and current stock price. • This cost was amortized over the life of the options. • But if there is no difference between the strike price and current stock price, then company need not to report it as a cost in the income statement.

17. Executive Incentives • “This award is treated as capital gain, not as income, which is an advantage to the CEO because capital gain taxes are lower than regular personal income taxes.”

18. Executive Incentives • Main Problem with the Grant Options • Even if the stock options are no appeared on the firm’s income statement, means no cost for company but a real economic lose. • A firm has 100 million outstanding share in the market ($1 per share) • If the executives exercise their options and sell their options (e.g. 10 million) in the stock market. • Now this will increase the numbers of outstanding shares in the market i.e. 100 + 10= 110 million shares.

19. Executive Incentives • Cont:- • This will directly effect the share price. • Simple rule of demand and supply. • Supply will directly effect the demand of share. • $100 millions are available (by having 100 million shares @ $1 per share) • Now $100 millions are available ( by having 110 million share @ $0.91 per share) • So it’s a lose for shareholders.

20. Executive Incentives 3. Stock Grants • Because of the governance failure in late 1990s and early 2000s, many firms have been looking for alternative forms of long-term incentive compensation. • A) Restricted Stock • Includes limitation that requires a certain length of time to pass or a certain goal to be achieved before the stocks can be sold.

21. Executive Incentives • B) Performance Sharing • Company’s stock given to executives only if certain performance criteria are met. • It could be viewed as bonuses for past performances. • More valuable for the CEOs because the firm stock prises has been increased.

22. Executive Incentives Does Incentive-Based Compensation Work In General • Two ways to examine • 1. Positive relation between firm’s performance and management compensation (ex post evidence) • The evidence show that the answer is pretty much “no” (study conducted over 2000 CEOs) • If the CEO have to increase the firm’s value by over $300 million to increase his/her compensation by a mere $1 million. • So the pay for performance sensitivity is very low.

23. Executive Incentives • 2. Positive relationship between management compensation and firm’s performances (ex ante evidence) • Perhaps CEOs or managers are risk-averse and their salaries are already large so why should they take risk. • But if CEOs or managers are risk-takers where risk sometimes pays off and sometimes it does not. • Finally, its difficult to relate the firm’s performances with the management compensations.

24. Executive Incentives • Summary • We discuss briefly principle-agent or agency problem. • How manager can effect different stakeholders. • Examples of management self-serving activities • Types of executive compensations • There are advantages and disadvantages of bonuses and permanent increases to salary. • But the question is whether these incentives based compensation really work or not.