1. By: 1. Kenneth A. Kim John R. Nofsinger And 2. A. C. Fernando

2. 3 rd Lecture

3.  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.

4.  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.

5. 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.

6.  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

7. 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.

8.  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.

9. S.NoCompanyCEOYearPackage 1 CHESAPEAKE ENERGY CORPAubrey K. McClendon2008100,069,201 2 NABORS INDUSTRIES LTDEugene M. Isenberg200859,834,630 3 ORACLE CORPLawrence J. Ellison200956,810,851 4 MERCK & COFred Hassan200949,653,063 5 GAMCO INVESTORS INCMario J. Gabelli200943,576,932 6 CBS CORPLeslie Moonves200943,238,875 7 THERMO FISHER SCIENTIFIC INCMarc N. Casper200934,283,774

10.  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

11.  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.

12.  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

13.  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.

14. 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.

15.  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.

16.  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.

17.  “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.”

18.  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.

19.  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.

20. 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.

21. ◦ 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.

22. 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.

23.  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.

24.  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.