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BU457 Midterm: Executive Compensation review

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Wilfrid Laurier University
Bixia Xu

Executive Compensation Review • Desirable properties of a performance measure o Sensitivity: rate at which the expected value of the measure responds to manager effort o Precision: the reciprocal of the variance of the noise in the measure o Generally, these properties have to be traded off. The lower the noise in net income and the greater its sensitivity to manager effort, the greater should be the proportion of net income to share price in determining the manager’s overall performance • Share price o High in sensitivity, low in precision o Low precision derives from the effects of economy wide factors. Example is if interest rates rise, expected effects on future firm performance will show up in share price. Even though no change in manager effort. • Net income o Low in sensitivity, high in precision How to increase the sensitivity of net income? • Reduce recognition lag o Net income “waits” until many aspects of manager effort are realized (eg. R&D, advertising, legal & environmental liabilities and capex programs) • Current value accounting reduces recognition lag o But decreases precision o Unclear whether current value accounting would result in net gain in importance for net income • Full disclose o More difficult for manager to disguise shirking by earnings management o Enables compensation committee to better evaluate earnings persistence Controlling length of manager decision horizon • That is, controlling the nature of manager effort o Short run/long run effort o Greater proportion of performance based on share price relative to net income increases long run effort relative to short run effort and vice versa o For example, to encourage more R&D (long run effort), owner can reduce the proportion of manager compensation based on net income and increase the proportion based on share price o Or does it? Effect of ESOs on manager effort leading up to 2007-2008 market meltdowns ▪ Effects of RBC proposed 2009 changes to compensation plan on manager decision horizon? ▪ RBC plan titled towards short run (since short and medium run awards depend on earnings). The decision horizon lengthening effect of ESOs can be question. Congruency of a performance measure • If performance measure (e.g. net income) is congruent to payoff, mix of short-run and long-run effort does not matter to firm owner (investor) o Each effort type equally effective in generating payoff • If net income not congruent to payoff (mor
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