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Chapter 10

Chapter 10 Notes (Key takeaways from the chapter) - .docx

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Brock University

Chapter 10 – Executive Compensation Executive Compensation Plan - Agency contract between the firm and its manager that attempts to align the interests of owner and manager by basing the manager’s compensation on one or more measures of the manager’s performance in operating the firm Are incentive contracts necessary? - Fama (1980) argues it is not necessary because the managerial labour market controls moral hazard o If a manager can establish a reputation for creating high payoffs for owners, that manager’s market value will increase o If a manager shirks, there will be lower payoffs on average, resulting in a decline in market value o Assumes efficient managerial labour market - Wolfson (1985) argues that forces of reputation help to motivate, but incentive contracts are still needed o Market forces reduce the moral hazard problem, but does not eliminate it The Theory of Executive Compensation - How to increase the sensitivity of net income o Reduce recognition lag by moving to current value accounting  Payoffs from manager effort show up in current net income  However, current value accounting decreases precision o Full disclosure, particularly of low-persistence items  Better evaluate manager effort and ability  More difficult for manager to disguise shirking by earnings management - Controlling length of manager decision horizon (control the nature of manager effort) o Short-run effort (e.g. cost control, maintenance, employee morale, advertising, and other day-to-day activities) o Long-run effort (e.g. planning, R&D, acquisitions) - Greater proportion of performance based on share price relative to net income increases long-run effort relative to short-run effort, and vice versa Congruent Performance Measure - If performance measure is congruent to payoff o Mix of SR and LR effort does not matter to firm owner o Each effort type equally effective in generating payoff - If performance measure is not congruent to payoff o Effort mix does matter o Owner can control manager’s effort mix through proportion of net income vs. share price-based compensation Role of Risk in Executive Compensation - Manager must bear some risk to motivate effort (otherwise moral hazard) o Downside risk – compensation may be less than expected o Upside risk – compensation may be more than expected - Lower performance measure precision  higher risk - Too little compensation risk reduces effort incentive - Too much compensation risk results in managers avoiding risky projects and excessive hedging (goal is to control compensation risk, not eliminate it) Chapter 10 – Executive Compensation - Relative Performance Evaluation – performance is measured by the difference between the firm’s net income and/or share price information and the average performance of a peer group of similar firms, such as other firms in the same economy or industry o Fine in theory, but hard to find in practice o Albuquerque (2009) argues firm size must also be taken into account since different-size firms are affected differently by industry-wide events - Bogey of compensation plan – controls downside risk o Incentive compensation does not kick in until some level of financial performance is reached (if the bogey is not attained, the contract does not award any incentive compensation) - Cap of compensation plan – controls upside risk - Role of Board, compensation committee o Determine the amounts of cash and stock compensation, and it has the flexibility to take special circumstances into account - Role of conservative accounting o Controls upsid
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