CORPORATE

GOVERNANCE

Kenneth Kim,
John Nofsinger &
Derek Mohr

3rd Edition
Pearson Prentice Hall

CHAPTER 2Executive Incentives

 Chapter overview
2

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
 Potential Managerial Temptations
3

A good manager should put the needs of other

stakeholders before his own.

However, if shareholders and the board of directors

cannot effectively monitor managers’ behavior,
then managers may be tempted to put their needs
first, even at the expense of shareholders.
 Examples of Self-serving Managerial Actions
4

Shirking (i.e. not working hard)

Hiring friends
Consuming excessive perks
Building empires
Taking no risks or chances to avoid being fired
Taking excessive risk to earn large bonuses
Having a short-run horizon if the managers is near
retirement
 Types of Executive Compensation
5

Base Salary and Bonus

The base salary is usually determined through
the benchmarking method (i.e., comparing to
similar size firms).
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.
Compare awarding bonuses to giving large
raises.
 Types of Executive Compensation (continued)
6

Stock Option
Executive stock options—the most common
form of market-oriented incentive pay—have value
only if stock price goes up.
Stock options are believed to align managers’
goals with shareholders’ goals.
Stock options have asymmetric incentives
Stock options can lead to increased risk taking
by managers
 Stock Option
7

Options and Accounting

Stock option’s favorable tax treatment for
both the executive and the company
Accounting cost and economic cost
FAS 123(R)
 Types of Executive Compensation (continued)
8

Stock Grants
—An alternative form of long-term incentive
compensation that avoids some governance
failures
• Restricted stock does not have asymmetric
incentives
• Performance shares can be viewed as
bonuses for past realized performance.
 Does Incentive-based Compensation Work in
General?
9

Two ways to examine the efficacy of incentive-

based compensation:
ex post evidence, pay-for-performance sensitivity
ex ante evidence
 Potential “Incentive” Problems with Incentive-
based Compensation
10

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
 Problems with Stock Option Incentives
11

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
 Another Problem with Executive Stock Options
12

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
 Real-World Examples
13

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
 Example: Xerox Corporation
14

70
Xerox executives sell $48 million worth of
options and $31 million in other stock.
60
Xerox Stock Price ($)

50

40

30

20

10
period of phony profits

0
Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02
 Expensing Executive Options:
An Easy Solution?
15

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
 Other Compensation
16

Club membership, financial advisors, luxury cars

and chauffeurs, personal travel, etc.
Retirement compensation
Company loan
 Crime and Punishment
17

An alternative way to solve the agency-problem is

to increase the penalty
The new Sarbanes-Oxley Act
 18
Percent of Total Pay

100%

10%
20%
30%
40%
50%
60%
70%
80%
90%

0%

Fixed Pay
Perquisites

Variable Pay
Argentina

Australia

Belgium

Brazil

Canada

China-Hong Kong
Around the World

China-Shanghai

France

Germany

India

Italy

Japan

Mexico

Netherlands

Singapore

South Korea

Spain

Sweden

Switzerland

Taiwan

United Kingdom

United States

Venezuela
International Perspective-CEO Compensation
 Summary
19

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.