Chapter 2

Executive Incentives

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Chapter overview

Potential Managerial TemptationsTypes of Executive CompensationDoes Incentive-based Compensation Work in General?Potential “Incentive” Problems with Incentive-based CompensationOther CompensationCrime and PunishmentInternational Perspective-CEO Compensation Around the World

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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.

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Examples of Self-serving Managerial Actions

Shirking (i.e. not working hard)Hiring friendsConsuming excessive perksBuilding empiresTaking no risks or chances to avoid being firedHaving a short-run horizon if the managers is near retirement

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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.

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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

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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)

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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.

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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

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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

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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

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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

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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

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Example: Xerox Corporation

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Xerox executives sell $48 million worth of options and $31 million in other stock.

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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

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Other Compensation

Club membership, financial advisors, luxury cars and chauffeurs, personal travel, etc.

Retirement compensation

Company loan

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Crime and Punishment

An alternative way to solve the agency-problem is to increase the penalty

The new Sarbanes-Oxley Act

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International Perspective-CEO Compensation Around the World

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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.