Corporate Governance. By: 1. Kenneth A. Kim John R. Nofsinger And 2. A. C. Fernando. Executive Incentives. 3 rd Lecture. Executive Incentives. Lecture Outline Briefly discussion on principle-agent or agency problem.
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Corporate Governance By: 1. Kenneth A. Kim John R. Nofsinger And 2. A. C. Fernando
Executive Incentives 3rd Lecture
Executive Incentives • Lecture Outline • Briefly discussion on principle-agent or agency problem. • How manager can effect different stakeholders. • Examples of management self-serving activities • Types of executive compensations • There are advantages and disadvantages of bonuses and permanent increases to salary. • But the question is whether these incentives based compensation really work or not.
Executive Incentives • Corporations are separated in between • Owners ( Stockholders) • Controllers ( Officers and executives) • This is the main cause of emerging problems. • i.e. principal-agent problem or agency problem • So effective solution is required i.e. • Incentives ( in this chapter) • Monitoring • Incentives solution means; • Tying executives wealth to the wealth of share holders to share the same goal.
Executive Incentives Potential Managerial Temptations • Manager’s action can affect the following; • Investors and lenders • The firm’s customers and suppliers • The firm’s employees • And of course himself • Good manager always think for the stakeholders first-not in common practice.
Executive Incentives • Examples of self-serving managerial actions include; • Shirking ( not working hard) • Hiring friends • Consuming excessive perks • Building empires ( making the firm as much as possible, even though it may hurt the firm’s per share value) • Taking no risks or chances to avoid being fired; and • Having a short-run horizon if the manager is near retirement-very dangerous
Executive Incentives Types of Executive Compensation • Company executives are compensated through different ways 1. Base Salary and Bonus • The CEO salary is determined through the benchmarking method-surveying the peers CEO salaries for compensation. • CEO salary has drifted upward, getting nice raises-competitive edge.
Executive Incentives • New CEOs making more than current CEOs. • Basic pay depends upon the characteristics of the firm, rather than the characteristics of the CEO. • So, large firm CEO will get more than small firm CEO. • Small firm can’t afford large firm CEO and vice versa.
Executive Incentives • Cash bonuses depends upon the firm’s previous year’s performance. • Based on; • Earning per share • Net Income-Dividend on Preferred Stock Average Outstanding Shares • Earnings before interest and taxes • Operational Revenue – Operating Expenses + Non Operating Income • Economic Value Added • Earnings – Cost of Capital
Executive Incentives • An advantage of awarding bonuses, as opposed to giving large raises, is that bonuses are one-time rewards for past realised performances, while raises are permanent additions to salaries for future unrealised performances. • Average bonus payments for CEOs in large firm was $1.5 million in 2004.
Executive Incentives • Advantages of Bonus • Appreciation for past performance • Motivation for future goals • Focus on quality • Focus on individual output • Bring innovation and creativity • Disadvantages of Bonus • Costly for company • Taxes from employees • Fairness and Jealousy Issues
Executive Incentives • Advantages of Permanent Addition to salary • Brings loyalty to organization. • No fairness and Jealousy issues • Increase is not on the basis of past performance- it’s a routine work of organization for employees. • Disadvantages • Discourage innovation and creativity • No past performance appreciation.
Executive Incentives 2. Stock Options • The most common form of market-oriented incentive pay • It allows the executives to buy shares of stock at a fixed price, called the exercise or the strike price. • The executives can get benefits from the differences of prices i.e. Market price of the stock minus strike price.
Executive Incentives • That’s how you can align manager’s goal with shareholder’s goals. • This alignment will, somehow, overcome the problem with the separation of ownership and control. • The most common length of the options contract is 10 years. • The median option-based award realized for CEOs in large firms was $2.7 million in 2004.
Executive Incentives • 2.1. Options and Accounting • Stock option is a cost for company, if there is a difference between strike price and current stock price. • This cost was amortized over the life of the options. • But if there is no difference between the strike price and current stock price, then company need not to report it as a cost in the income statement.
Executive Incentives • “This award is treated as capital gain, not as income, which is an advantage to the CEO because capital gain taxes are lower than regular personal income taxes.”
Executive Incentives • Main Problem with the Grant Options • Even if the stock options are no appeared on the firm’s income statement, means no cost for company but a real economic lose. • A firm has 100 million outstanding share in the market ($1 per share) • If the executives exercise their options and sell their options (e.g. 10 million) in the stock market. • Now this will increase the numbers of outstanding shares in the market i.e. 100 + 10= 110 million shares.
Executive Incentives • Cont:- • This will directly effect the share price. • Simple rule of demand and supply. • Supply will directly effect the demand of share. • $100 millions are available (by having 100 million shares @ $1 per share) • Now $100 millions are available ( by having 110 million share @ $0.91 per share) • So it’s a lose for shareholders.
Executive Incentives 3. Stock Grants • Because of the governance failure in late 1990s and early 2000s, many firms have been looking for alternative forms of long-term incentive compensation. • A) Restricted Stock • Includes limitation that requires a certain length of time to pass or a certain goal to be achieved before the stocks can be sold.
Executive Incentives • B) Performance Sharing • Company’s stock given to executives only if certain performance criteria are met. • It could be viewed as bonuses for past performances. • More valuable for the CEOs because the firm stock prises has been increased.
Executive Incentives Does Incentive-Based Compensation Work In General • Two ways to examine • 1. Positive relation between firm’s performance and management compensation (ex post evidence) • The evidence show that the answer is pretty much “no” (study conducted over 2000 CEOs) • If the CEO have to increase the firm’s value by over $300 million to increase his/her compensation by a mere $1 million. • So the pay for performance sensitivity is very low.
Executive Incentives • 2. Positive relationship between management compensation and firm’s performances (ex ante evidence) • Perhaps CEOs or managers are risk-averse and their salaries are already large so why should they take risk. • But if CEOs or managers are risk-takers where risk sometimes pays off and sometimes it does not. • Finally, its difficult to relate the firm’s performances with the management compensations.
Executive Incentives • Summary • We discuss briefly principle-agent or agency problem. • How manager can effect different stakeholders. • Examples of management self-serving activities • Types of executive compensations • There are advantages and disadvantages of bonuses and permanent increases to salary. • But the question is whether these incentives based compensation really work or not.