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CHAPTER 18

HOW MANAGERIAL INCENTIVES AFFECT FINANCIAL


DECISIONS

18.1)
There are two reasons that managers want their organizations to grow. First, a growing
organization can reduce the probability of bankruptcy and financial distress. This can increase
managers job security and it can also allow managers to reward their employees. Second, the
larger the size of the firm, the more the firm can increase the financial and non-financial
compensation of the manager.

18.2)
Ownership concentration is determined primarily by two factors: (1) a firm s size or its
development stage, and (2) the type of firm or the kind of assets it owns
A firm that generates large control benefits usually has higher ownership concentration. For
example, in the entertainment and media industries, owners do not want to give up ownership
because they can enjoy the numerous non-financial benefits associated with control of these
industries.
Firms with a lot of intangible assets usually have greater agency problems and thus higher
ownership concentration in order to mitigate these problems.
A firm that is smaller or in an early stage of development generally has an owner or entrepreneur
with a higher ownership percentage.

18.3)
In the first scenario, the CEO will own approximately (25/75) = 1/3 of the firm and may therefore
lose some control. There might then be an offsetting impact on his incentives. Under the
alternative scenario, the CEO of High Tech retains 51% of the firm and thus indirectly controls
the subsidiary as well. However, since his indirect ownership of the subsidiary is less than his
ownership of the parent, he will have an incentive to transfer resources from the subsidiary to the
parent. It will be easier to motivate the manager of Super Tech if Super Tech has its own publicly
traded stock.

18.4)
Firm 1 generally has the optimal ratio of debt as described in this text. Firm 2 generally has a
higher debt ratio since the board wants to reduce the manager s investment flexibility. Firm 3 is
expected to have a lower debt ratio since the manager prefers maximum investment flexibility and
wishes to minimize bankruptcy risk.

18.5)
If it is more difficult to extract private benefits from partial control over management, large
shareholders will own fewer shares and monitor less. Because of the free-rider problem, there will
be too little monitoring in the absence of these private benefits. To solve the free-rider problem,
the level of private benefits should just compensate shareholders for the social benefits they create
by monitoring.

18.6)
It is much easier to base compensation for the Chevron CEO on relative performance. The
Chevron CEO can be judged by how well the firm has done relative to changes in the price of oil

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and relative to its competitors. Using relative performance to compensate the CEO of Chrysler
would be more difficult. The auto industry is more concentrated, implying that the CEO s
decisions affect the value of Chrysler s competitors. If auto company CEOs all had relative
performance compensation packages, they would compete more aggressively which would make
the industry less profitable. This would not be as big a problem in the oil industry, which is
already very competitive.

18.7)
Firms with higher market-to-book ratios generally have more intangible assets and, hence, there is
more scope for the CEO to take actions that benefit him personally, at the expense of the firm.
Therefore, stock-based compensation is needed to align the executives incentives. One might
also posit that the causation is reversed. Firms with more stock-based performance have higher
market-to-book ratios because they are better managed and thus achieve higher market values.

18.8)

Managers will hold a larger percent of the shares, thus making their incentives more aligned with
shareholder value. In addition, bankruptcy is more likely following the transaction, giving the
managers a smaller margin for error. For these reasons, the firm s managers are less likely to
choose negative NPV investments that benefit them personally.
Because of the higher leverage, the managers may have an incentive to increase risk in order to
benefit shareholders (and their own shares) at the expense of debt holders. However, if the
managers are very risk averse, they may actually be less likely to take on more risk because they
will personally find bankruptcy costly.
Given the high borrowing costs, the firm is likely to choose projects that pay off very quickly.

18.9)

The Chicago Bulls coach can be rewarded based on the success of his team or based on the quality
of his decisions. If the team s success were completely under the coach s control, then it would
make sense to base the coach s bonus solely on the Bull s winning percentage. However, veteran
players get injured, rookies turn out to be either much better or much worse than anticipated, and
numerous other factors beyond the coach s control affect winning percentages. In summary, great
coaches can be unlucky and therefore fail to deliver a winning season.

One alternative is to reward the coach on the basis of the quality of his decisions. In theory this
can be done; however, in reality, an evaluation of this type is likely to be very subjective and may
not provide an accurate assessment of the quality of his coaching.
In reality, we expect that a combination of the approaches should be used.

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