Chapter 2
Executive
Incentives
Chapter overview
Potential Managerial Temptations
Types of Executive Compensation
Does Incentive-based Compensation Work in
General?
Potential “Incentive” Problems with Incentive-based
Compensation
Other Compensation
Crime and Punishment
International Perspective-CEO Compensation
Around the World
2
Potential Managerial Temptations
A good manager should put the needs of
other stakeholders before his own.
However, if shareholders cannot effectively
monitor managers’ behavior, then managers
may be tempted to put his needs first, even
at the expenses of shareholders.
3
Examples of Self-serving Managerial
Actions
Shirking (i.e. not working hard)
Hiring friends
Consuming excessive perks
Building empires
Taking no risks or chances to avoid being
fired
Having a short-run horizon if the managers is
near retirement
4
Types of Executive Compensation
Base Salary and Bonus
The base salary is usually determined through
the benchmarking method.
At the end of every year, CEOs often receive
cash bonuses whose size is computed based on
the performance of the firm over the past year.
Comparison of awarding bonuses with giving
large raises.
5
Types of Executive Compensation
(continued)
Stock Option
Executive stock options—the most common
form of market-oriented incentive pay.
Stock options give the executive of the firm the
incentive to manage the firm.
Stock options are believed to align managers’
goals with shareholders’ goals.
Stock options have asymmetric incentives
6
Stock Option
Options and Accounting
Stock option’s favorable tax treatment for both
the executive and the company
Accounting cost and economic cost
FAS 123(R)
7
Types of Executive Compensation
(continued)
Stock Grants
—An alternative form of long-term incentive
compensation that avoids governance failure
• Restricted stock does not have asymmetric
incentives
• Performance shares can be viewed as
bonuses for past realized performance.
8
Does Incentive-based Compensation
Work in General?
Two ways to examine the efficacy of
incentive-based compensation:
ex post evidence, pay-for-performance sensitivity
ex ante evidence
9
Potential “Incentive” Problems with
Incentive-based Compensation
Problems with Accounting-Based Incentives
Forego costly research and development that
might be beneficial to the firm
Accounting profits may be manipulated
CEOs may place too much focus on
manipulating short-term earnings
10
Problems with Stock Option Incentives
CEOs might forego increasing dividends in favor of
using the cash to try to increase the stock price
CEOs have a tendency to pick a higher risk business
strategy
Stock options may be too far underwater to motivate
the manager effectively
CEOs may try to do what they can to time stock price
movements to match the time horizons of their stock
options
11
Another Problem with Executive Stock
Options
Stock prices are affected by company
performance but also by many other factors
beyond its control
Repricing previously issued options may let
options lose their effectiveness
12
Real-World Examples
Disney CEO Michael Eisner
—Stock options create the possibility that
only short-term value will be created, not
long-term value
Management’s Behavior at Xerox
—Managers may manipulate accounting
profits
13
Example: Xerox Corporation
70
Xerox executives sell $48 million worth of
options and $31 million in other stock.
Xerox Stock Price ($)
60
50
40
30
20
10
period of phony profits
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
14
Jan-90
0
Expensing Executive Options:
An Easy Solution?
Expensing executive option—the cost of stock
options issued to employees and executives should
be treated as an expense on the granting firm’s
financial statements.
Three reasons of expensing executive options:
To have better disclosure and account for the real cost of using
options as compensation
To reduce the amount of options executives receive and reduce
their total compensation
To reduce CEO’s incentive to time the market
15
Other Compensation
Club membership, financial advisors, luxury
cars and chauffeurs, personal travel, etc.
Retirement compensation
Company loan
16
Crime and Punishment
An alternative way to solve the agencyproblem is to increase the penalty
The new Sarbanes-Oxley Act
17
Perquisites
18
Variable Pay
Canada
Brazil
Belgium
Australia
Venezuela
United States
United Kingdom
Taiwan
Switzerland
Sweden
Spain
South Korea
Singapore
Netherlands
Mexico
Japan
Italy
India
Germany
France
China-Shanghai
China-Hong Kong
Fixed Pay
Argentina
Percent of Total Pay
International Perspective-CEO
Compensation Around the World
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Summary
Stock and option incentives are believed to
solve agency-problem
However, whether or not the incentives work
results in much debate
If incentive compensation is imperfect, then
monitors are needed.
19