Notes on Compensation
Dr. Edward L. Millner
Phone: 828-1717
email: emillner@vcu.edu
URL: www.people.vcu.edu/~emillner/FastTrack
Primary Learning Objective: To identify compensation schemes that align
employees interests with the interests of the owners of the firm.
Question: What are a manager’s goals?
The separation of ownership and control creates a principle-agent problem
between owners and managers

Managers are agents hired by owners to represent the interests of the
owners in determining the courses of action taken by the firm

Owners unable to monitor perfectly

Managers have interests that conflict with the principles that they are hired
to represent

Compensation schemes have the potential of reducing or exacerbating the
conflict of interests inherent in owner-manager relationships
Two types of incentives may align the interests of managers and owners

Internal contracts
o Bonuses
o Stock ownership and options

External incentives
o Reputation
o Takeover
Question: Page 219 of the text documents that fast-food restaurants owned by
the company are typically less profitable than restaurants owned by the
franchisee.
a. Is the superior profitability of the restaurants owned by the company
relative to the restaurants owned by the franchisee surprising? Why or
why not?
b. Does the superior profitability of the restaurants owned by the company
relative to the restaurants owned by the franchisee indicate that franchisee
ownership is superior for the parent company? Why or why not?
c. How might the compensation scheme for managers of restaurants owned
by the company be altered to improve the performance of the restaurants?
Homework 1
Question: Suppose that a CEO is currently paid a bonus at the end of each fiscal
year, with the size of the bonus being tied directly to the profits earned by the firm
in that year. The Board of Directors is considering making the bonus a fixed
amount and making it contingent upon reaching a specified level of profitability in
that year. Would you recommend the implementation of the change? Why or
why not?
Question: A compensation scheme that pays the CEO with large quantities of
stock presumably aligns the interests of the CEO closely with the interest of the
owners. How might a CEO who holds large quantities of stock behave in a way
that deviates from the interests of the firm? How might these problems be
remedied?
Question: Would paying a CEO in stock options do a better job of aligning the
interests of the CEO and the firm than payment in stocks? If not, what explains
the increased popularity of using stock options in the 1990’s?
Question: A firm currently pays bonuses to each of four division heads, with the
size of the bonus being tied directly to the profitability of each division. The
Board of Directors is considering a proposal to pay only one large bonus to the
head of the division showing the highest return to equity in that year. What
changes in behavior would such a Tournament based compensation scheme
induce?
A principle-agent problem exists between managers and workers

Workers are agents hired by managers to represent the interests of the
managers to carry out managers directives

Managers are unable to monitor perfectly

Workers have interests that conflict with the principles that they are hired
to represent

Compensation schemes have the potential of reducing or exacerbating the
conflict of interests inherent in manager-worker relationships
Two types of incentives may align the interests of managers and workers

Internal contracts
o Profit sharing
o Revenue sharing
o Piece rates
o Time clocks
o Spot checks
o Stock ownership and options

External incentives
o Reputation
o Dismissal
Homework 2