Clifford W. Smith, Jr.
Spring 2007
Presentation 3
* Covers readings on course outline through Brickley/Smith/Zimmerman, Chap 14 and 15
FIN413 – Overhead 3

Executive Compensation
 Benchmark Compensation Plan
Suppose I offer a corporate manager a series of prespecified salary payments -- from the time he is hired until the time he retires -- with the only contingency that if the firm goes bankrupt, he will be fired, and his salary payments will be terminated.

What are the conflicts of interest that will likely arise between owners and managers under this benchmark compensation plan?
FIN413 – Overhead 3

Conflicts of Interest between
Owners and Managers
 Effort Problem
 Horizon Problem
 Differential Risk Exposure Problem
 Over Retention Problem (Payout Policy)
 Under Leverage Problem
FIN413 – Overhead 3

Potential "Solutions" to the
Owner/Manager Conflicts
 Choice of Organizational Structure
FIN413 – Overhead 3

Potential "Solutions" to the
Owner/Manager Conflicts
 Choice of Organizational Structure
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers
FIN413 – Overhead 3
 Internal and External Labor Markets

Potential "Solutions" to the
Owner/Manager Conflicts
 The Market for Corporate Control
 Incentive based compensation contracts
–
– explicit contracts implicit contracts
FIN413 – Overhead 3

FIN413 – Overhead 3
“Suffice it to say that one is the result of an extremely hostile takeover.”

FIN413 – Overhead 3

Salary

Pension

Insurance

Perks

Salary

Typically largest component (but not always)

Within contracting period salary is fixed
(close to our benchmark case)

Implicit contract to renegotiate salary in good faith based on performance

No one in the firm determines his/her own salary (compensation committee of board comprised of outside boardmembers)
FIN413 – Overhead 3

Pension Plans
 Defined Benefits vs defined contribution plans
 Vested vs nonvested plans (ERISA)
FIN413 – Overhead 3

Tax Deferral Effect of Pensions
Salary
Raise
Taxes
Interest
Taxes
Total
FIN413 – Overhead 3
Pension
+
100.00
Contribution
-
50.00
Interest
+
5.00
Taxes
-
2.50
52.50
Total
+
100.00
+
10.00
-
55.00
55.00

Stock Option Plans
 Stock options granted to managers
– Typically have approx. 5 years to expiration
–
–
–
European options (cannot be exercised early)
Restricted (cannot be sold before expiration)
The option is actually a warrant (when exercised, the number of shares outstanding increases), but dilution effect is small.
FIN413 – Overhead 3

Stock Option Plans
Impact of option plan on:
– effort problem
– horizon problem
– risk exposure problem
– payout problem
Stock
Option
X
FIN413 – Overhead 3
S*

Other Stock-Based
Compensation Plans

Stock Appreciation Rights (SARs)

Restricted Stock

Phantom Stock

Dividend Units

Base manager's pay on "abnormal" stock return
FIN413 – Overhead 3

Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have some form of bonus plan)
Pool of Available Funds
Contributions to Pool
Earnings
FIN413 – Overhead 3

Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have some form of bonus plan)
Pool of Available Funds
Contributions to Pool
Earnings
FIN413 – Overhead 3

Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have some form of bonus plan)
Pool of Available Funds
Contributions to Pool
Earnings
FIN413 – Overhead 3

Bonus Plans
 Impact of bonus plan on
– effort problem
– risk exposure problem
– payout problem
– horizon problem
 Long-term performance plans -- similar to bonus plans, but based on 3 to 7 year earnings performance
 Performance units
FIN413 – Overhead 3

Bonus Plans
 The use of accounting numbers vs stock prices for incentive compensation plans
–
–
–
Accounting numbers allow disaggregation of performance measures
Accounting numbers can provide perverse incentives
Accounting numbers subject to manipulation
 Top managers (who set accounting policy) typically compensated with stock-based plans.
Lower level managers more likely to receive bonus.
FIN413 – Overhead 3

Potential "Solutions" to the
Owner/Manager Conflicts
 Choice of Organizational Structure
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers
FIN413 – Overhead 3
 Internal and External Labor Markets

Bonus Plans
What determines where a divisional manager's bonus payment falls along this spectrum?
Divisional Firm
Performance Performance
FIN413 – Overhead 3

Investment Opportunity Set
Assets in
Place
Growth
Opportunities
Leverage
Compensation
Level of Pay
Conditional on
Performance
FIN413 – Overhead 3
High
Low
Low
Low
High
High

Level of Use of
CompenStock
Growth Options (Merck) Higher Higher
Credence Goods (Eastern) Higher Higher
Product Warranties (Yugo) Higher Higher
Future Product Support
(Yugo/Wang)
Supplier Financing (Campeau)
Closely Held Firm
Size
Regulation
Tax Credits
Marginal Corporate Tax Rate
Marginal Personal Tax Rate
FIN413 – Overhead 3
Higher
---
Higher
Higher
Lower
---
---
---
Higher
---
Higher
Higher
Lower
---
Lower
Higher
Use of
Bonus Plans
Lower
Higher
Higher
Higher
---
Higher
Higher
Lower
---
Lower
Higher

Investment Opportunity Set
Cost of Debt
(Underinvestment)
Benefits of Debt
(Free Cash Flow)
Predicted Leverage
FIN413 – Overhead 3
Assets in
Place
Low
High
High
Growth
Opportunities
High
Low
Low