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31 Cards in this Set
- Front
- Back
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Managerial labor markets ______ the severity of moral hazard. |
reduce |
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Executive Compensation Plan |
agency contract between the firm and its manager that attempts to align the interests of owners and manager by basing the manager's compensation on one or more measures of the manager's performance in operating the firm |
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executive compensation contracts require a delicate balance of ______ , ______, and ______ |
- incentives - risk - decision horizon |
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What are the four main incentive components? |
- Salary - Short Term: based on earnings/individual achievement - Long Term: stock options whose value depends on share price performance - Mid Term: value depends on both |
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What are some of the problems with using net income alone as a performance measure? |
- time lag between hard work and increased income - not a single activity (MGMT has no control over other factors affecting NI) |
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What are some of the problems with using share price alone as a performance measure? |
affected by economy-wide and industry-wide factors |
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What is the solution to these problems? |
Measure performance based off a combination of net income and share price |
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The more ______ net income is, the ______ it should be used |
precise more |
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Managers must bear some ______ ______ if effort is to be motivated. |
compensation risk |
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The more risk managers bear, the more _______ they expect to receive. |
compensation |
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Efficient Incentive Compensation Plan |
try to get the most motivation for a given amount of risk imposed or equivalently, the least risk for a given level of motivation |
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What are the 4 methods in which a company can control a manager's risk?
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- Relative Performance Evaluation - Bogey - Cap - Compensation Committee |
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Relative Performance Evaluation |
performance is measured by the difference between the firm's net income and/or share price and the average performance of a peer group of similar firms |
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The RPE filters out ______ ______ that the industry faces as a whole. An example if this is ..... |
common risk ex. economic downturn |
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Bogey |
the lower threshold for bonus calculation incentive compensation does not kick in until some level of financial performance is reached |
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What risk does a Bogey protect from?
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the risk of having negative earnings if the Bogey is not attained, no compensation is awarded protects MGMT from having to pay in to the company if a loss is reported |
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Cap |
the upper threshold for bonus calculation incentive compensation ceases beyond certain level |
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What risk does a Cap protect from? |
the risk of MGMT having everything to gain and nothing to loose, resulting in poor decision making |
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Compensation Committee |
the ultimate responsibility to determine the amounts of cash and stock compensation |
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A compensation committee has _______ to take special circumstances into account. An example of this is.... |
flexibility when a bogey is not reached, they may still reward a bonus |
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How can managers shed risk? |
-selling their shares/options and investing in less risky assets - excessive hedging |
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Should companies limit the way MGMT can shed risk? If so, how? |
Yes, it is essential that some risks remains Place limitations in the contract (cannot sell shares, limit hedging behaviour) |
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Lambert & Larcker's study found that: ______ is more correlated to compensation than ______ |
net income share value |
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Lambert & Larcker's study found that: share value more correlated to compensation when net income is ______. |
noisy |
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Lambert & Larcker's study found that: compensation for growth companies is more correlated to ______ because ..... |
share value net income is less indicative of management's efforts during growth |
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Lambert & Larcker's study found that: when net income is not informative to investors, it is very informative for _______ |
compensation plans |
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Power Theory
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suggests that executive compensation in practice is driven by manager opportunism, not efficient contracting |
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In what 2 ways is executive compensation opportunistic? |
- MGMT can influence BOD - MGMT can camouflage excessive comensation |
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How can MGMT influence the BOD? |
- influence on director appointment - director reputation may feel threatened |
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How can MGMT camouflage excessive compensation? |
- hiring compensation consultant to add legitimacy - consultant reputation may feel threatened - tie compensation to peer groups - creates pressure for the ratchet effect |
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What role does financial accounting play in motivating executive performance and controlling manager power? |
- full disclosure (better relation of pay to performance) - expensing ESOs (help control their abuse and encourage efficient compensation vehicles) |
