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Lecture 9

BU457 Lecture 9: Executive Compensation

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Wilfrid Laurier University
Bixia Xu

Executive Compensation • An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and managers by absing the manager’s compensation on one or more measures of the manager’s performance in operating the firm • Many plans based on 2 metrics: Net Income and Share Price • However, analyses of Holmstrom (1979) and Feltham & Xie (1994) suggest multiple measures increase contracting efficiency • Unless NI has desirable qualities of sensitivity and precision it will not be informative about manager effort. Will not measure performance efficiently and won’t enable markets to value manager worth. Will be “squeezed out” of efficient compensation plans. Are Incentive contracts necessary? No – Farma (1980) says not necessary • Managerial reputation within the labour market enough to motivate manager to work hard • Manager who is tempted to shirk looks ahead to future periods, the present value of reduced future compensation will be equal or greater than the immediate benefits of shirking. Thus, will not shirk. • Assuming that managerial labour market works well o Manager may try to “fool” market by opportunistically managing earnings to cover up shirking o Thus labour market subject to adverse selection & moral hazard o Multi-period shirking will be eventually discovered, with reputation destroyed for manager o Question is: are the expected costs of lost reputation strong enough to supply the missing effort motivation? If yes, incentive contract not needed. • Farma also argues that shirking will be detected and reported by managers below a manager who want to get ahead (“internal monitoring”) o Study by Arya, Fellingham & Glover (1997)(AFG) o Designed model with 1 owner and 2 risk averse managers who have a joint, observable payoff in each period o Owner can’t observe individual manager so one way to motivate managers is offer each an inventive contract taking advantage of the fact that managers can observe each other. o Since joint payoff, if 1 manager shirks, payoff for both reduced. Each manager will threaten the other and lead to no shirking. o If contract designed properly and threat is credible, both managers work hard in both periods. Contract is more efficient since less risk than a sequence of 2 signle period contracts. Managers can attain reservation utility with lower compensation. • If management contemplates the downwards effect of current shirking on the reservation utility of future employment contracts shirking will be deterred • Yes: • Forces of reputation help to motivate manager but incentive contracts still needed • Suggests that managerial labour markets do not work fully well Oil & Gas drilling example subject to moral hazard & adverse selection: • General partner and limited partner involved. General provides expertise and pays some costs and limited provides capital. • General does work on drilling so knows the results of drilling. Leads to “non- completion incentive problem”. Once drilled, a well should be completed/brought into production if expected revenues, R, exceed the costs of completion • Completion costs paid by general partner, so general receives, say, 40% of R then only worthwhile to complete for him if 0.4R is greater than completion costs. Since only general knows R (limited doesn’t) a well may not be completed. • Investors aware of this problem so will bid down prce to buy in. Question is can general partner ease conerns by establishing reputation? • Study showed that higher a general partner’s past success in generating return, the more they received from limited partners because of reputation • Thus, market forces can reduce the managers’ moral hazard, they do not eliminate it. Therefore, effort incentives based on some measure of payoff still necessary. Managerial Compensation Plan RBC Compensation Plan • Components of senior management compensation o Salary o Short term incentive bonus (cash/deferred share units) ▪ Based on earnings and individual acheivement o Mid term (deferred share units) o Long term (employee stock options) ▪ Value depends on share price performance • Proposed changes to compensation plan in 2009 o Deferral of bonus payments o Claw back of bonus if fraud o Greater weight on individual non-financial performance measures o Increased required executive stock holdings • Effects on
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