Executive Incentives

Cortez, AngelaObero, Queenie

Padua,AlleinPepillo, JonalynRomero, Luiza

Cahila, Kim

Potential Managerial Temptations

•A manager has a variety of stakeholders that are affected by her actions.

Example Of self-serving managerial actions include:

• Shirking• Hiring friends• Consuming excessive perks• Building empires• Taking no risks or chances to avoid being fired• Having a short-run horizon if near retirement

Types of Executive Compensation

1. Base Salary and Bonus-Determined through the

benchmarking method

*BENCHMARKING METHOD*- This method is where the

compensation committee of the board of directors surveys peer CEO salaries for comparison.

Types of Executive Compensation

2. Stock Options- Most common form of

market-oriented incentive pay.- are contracts that allow

executives to buy shares of stock at a fixed price called “strike price”

*Stock Grants* - Alternative forms of long-term incentive

compensation

Two Types of Stock Grants:1. Restricted Stock

- Includes a limitation that requires a certain length of time to pass or a certain goal to be achieved before the stock can be sold. 2. Performance Shares

- Refer to a company’s stock given to executives only if certain performance criteria are met.

Types of Executive Compensation

Does incentive-based compensation work in general?

There are two ways to examine whether or not incentive-based compensation works

-First, one could try to see if there is a positive relation between firm performance and management compensation. - defined as ex post evidence - Have managers been properly rewarded for increasing the firms' value? If the answer is 'yes', then we could surmise that incentive compensation works.

Does incentive-based compensation work in general?

-Another way to assess the efficacy of incentive-based compensation is to see if those firms that enacted these mechanisms subsequently experienced superior performance. - defined as ex ante evidence. - Once managers are given incentives, then did the firms subsequently perform well? Intuitively we might expect the answer to be 'yes' but surprisingly the evidence is mixed.

Potential “incentive” problems with incentive-based compensation

• Problems with accounting-based incentives

-the used of accounting profits to measure performance has several potential drawbacks.

1. to boost accounting profits, CEO has an incentive to forego costly research and development that might make the

firm more profitable in the future than in the present.2. accounting profits may be manipulated.

3.the bonus plan is developed a new each year and, if the threshold cannot be met one year, the CEO has an incentive to move earnings from present year to the future.

Problem with Stock Options Incentives

1. Shareholder returns combine both stock price appreciation and dividends. The stock is only affected by price appreciation.

2. The stock price is more likely to increase when the CEO accepts risky projects.

3. stock option lose some incentive for the CEO if the stock price falls too far below the strike price.

4. CEOs may try to manipulate earnings and thus maximize profits in one target year to make the stock price more favorable for exercising options.

Another Problem with Executive Stock Options

• Stock Options Problems -Stock options are tied to the firms stock

price, which help align incentives but executives only have partial influence on stock prices.

- Stock prices are affected by:* company performance* economy

Another Problem with Executive Stock Options

• Options lose their effectiveness when stock price falls too far below the strike price.

To re-establish motivation for the executives:- reprice previously issued options- risky company projects