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Chapter 2

Executive Incentives/Dr. Heba Ajlouni

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

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.

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

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.

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

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)

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.

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

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


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


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


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

Example: Xerox Corporation

70 60
Xerox executives sell $48 million worth of options and $31 million in other stock.

Xerox Stock Price ($)

50 40 30 20 10
period of phony profits

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01



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


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


Crime and Punishment

An alternative way to solve the agencyproblem is to increase the penalty The new Sarbanes-Oxley Act


China-Hong Kong China-Shanghai France Germany India Italy Japan Mexico Netherlands Singapore South Korea Spain Sweden Switzerland Taiwan United Kingdom United States Venezuela

Percent of Total Pay
100% 10% 20% 30% 40% 50% 60% 70% 80% 90% 0%

International Perspective-CEO Compensation Around the World

Fixed Pay
Argentina Australia Belgium Brazil Canada


Variable Pay

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.