Executive Incentives

1
Chapter 2

• 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 optionsthe 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 options 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
• Managements Behavior at Xerox
• Managers may manipulate accounting profits

14
Example Xerox Corporation
15
Expensing Executive Options An Easy Solution?

• Expensing executive optionthe cost of stock
  options issued to employees and executives should
  be treated as an expense on the granting firms
  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 CEOs 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.