INTRODUCTION invested with the firm at a fixed

INTRODUCTION

The CEO has
the highest power in a firm to make investment decisions that can affect its
performance. CEOs with no proper incentives can be risk aversive (Salehnejad,
2017a). “It’s not how much you pay, but how” (Jensen; Murphy, 1990) tell us
that mere fixed pay is not enough for the CEOs to perform on a long term basis.
It should be structured in such a way which offers both stock and options, and
fixed salary (Edmans, 2014). So an appropriate incentive has to be worked out
for the CEO for the company’s long term investments that will expand the growth
potential of the firm and increase its market value. Most of the firms
incentivizing the CEO can be understood from the fact that in the US, CEOs earn
373 times the average worker (Edmans, 2016). Imprudent risk taking should also
be avoided. Compensation schemes should be used to avoid this as these schemes
will “delay the CEO’s receipt of a certain
amount of current-year salary and bonus, leaving it invested with the firm at a
fixed rate of return until retirement or even sometime after retirement”
(Salehnejad, 2016 id). In order to create long term value, a compensation
scheme must be structured which will compel the CEO to act on their best
interests. The principal-agent problem should be solved by the optimal
structure by aligning the interests of the CEO and shareholders.

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PRINCIPAL-AGENT
PROBLEM

The
shareholders or principals of a firm may be too busy to manage the firm, so
they hire managers or in this case agents to manage it for them. The principal
agent problem is the difficulties that arise due to the separation of ownership
and control (Salehnejad, 2017 ls). There are certain assumptions regarding the
principal agent problem that has to be considered before developing the optimal
incentive system.

(Evidence)

Firstly, the
conflict of interests which refers to the difference in the interests of the
principal and the agent. The shareholder’s interest is the value the agent
creates while the agent’s interest is to maximize his/her earnings (Salehnejad,
2017 ls).

Second
assumption is the information asymmetries. As the shareholders are not
concentrated and dispersed that the information that the shareholders receives
on the actions of the agent are very limited. Knowledge of the shareholders
will be limited to judge the actions of the CEO. The large number of
shareholders implies there is a chance of conflicting views (Salehnejad, 2017
ls).

Third
assumption is that monitoring can be costly. Monitoring the actions of the
agent or the CEO can be challenging as it can be very costly. Appointing
“corporate boards are equally subject to agency problems” (Salehnejad, 2017
ls). Furthermore, the performance of the firm is highly dependent on the state
of the economy.

Fourth,
managers tend to be more risk-aversive than shareholders would like them to be
(Eisenhardt, 1989). The managers interest is to earn maximum incentive so all
decisions will be short termed as opposed to the long term investments in favor
of the firm. The CEO will prefer safe short term projects with low return
ratios.

Lastly, the
manager’s effort determines the firm’s revenue. The better the manager
performs, the higher the revenue the firm generates and vice-versa (Salehnejad,
2017 ls).

The shareholders
do not have the complete information regarding the CEO’s activities and the
firm’s investment opportunities, so designing a contract specifying and
enforcing the managerial action to be taken at each stage of the world is
impossible. “In these situations, agency theory predicts that compensation
policy will be designed to give the manager incentives to select and implement
actions that increase share holder wealth” (Jensen; Murphy, 1990). In addition,
an element that measures the firm’s performance independently of the firm’s
profit to ensure that the manager is not only rewarded for his efforts but also
to encourage risky investment projects should be included in an effective
system (Salehnejad, 2017).

The agent’s
total compensation will include a salary and a bonus rate. This can be
understood using a linear equation w=s+b.y, where w is the total compensation,
s is the salary, b is the bonus rate and y is the agent’s output. The variable
part of the compensation is dependent on the agent’s performance. So the basic
formula is:

S(e) = K + ??(e)6

Maximizing ?(U) = ?(S
– c(a)) is the aim of the agent where c(a) refers to the cost of action. The
optimal system would be lower the fixed salaries below the market competitive
levels and a high variable part (Murphy, 2009).

One of the
top energy company Enron went bankrupt because of the principal-agent problem. “Most of the
top executives were tried for fraud after it was revealed in November 2001 that
Enron’s earnings had been overstated by several hundred million dollars” (www.cnn.com,
2013). Apparently, Enron shares were worth $90.75 at their peak in August 2000
and dropped to $0.67 in January 2002 (www.cnn.com,
2013). There are numerous cases like the failure of Enron which displays
the severity of the principal agent problem. (Change company)

COMPENSATION
PAY SCHEMES AND INVESTMENT BEHAVIOR

Compensation
schemes are really important for aligning the interests of the principal and
the agent. The general formula for compensation schemes as shown above is S(e) = K + ??(e).

Compensation
schemes comprise of both pay structure and pay levels. The pay level refers to the amount the agent receives
and the pay structure refers to the structure of the compensation payment
(Salehnejad, 2017 ls). The
pay level was on a decline during the World War II and kept declining till late
1940s. It was in the 1970s that the CEO compensation increased rapidly and
continued until the end of the sample in 2005 with the annual growth rates reaching
more than 10% (Frydman; Jenter, 2010). Executive compensation had increased for
firms of all sizes. “For CEOs of
S&P 500 firms, the median level of pay climbed rapidly from $2.3m in 1992
to a peak of $7.2m in 2001” (Frydman; Jenter, 2010). The compensation premium of managing a larger
firm ha s increased as the growth in compensation pay is steeper in larger
firms (Frydman; Jenter, 2010). As firms tend to grow bigger, the compensation
for the CEOs also grows bigger. “If
companies become larger across the economy, the returns to employing talented
managers rise and this competition bids up wages” (Edmans; Gabaix, 2009)
forcing the principal or shareholders to formulate a balanced pay structure and
pay level.

 The
five basic components of most CEO packages are: salary, annual bonus, payout
from long-term incentive plans, restrictive option grants, and restricted stock
grants. The CEO in addition to this often receive contributions to defined?benefit
pension plans, various perquisites, and, in case of their departure, severance
payments but the relative importance of these compensation elements has changed
considerably over time. In the 1980’s, 74% of the compensation pay was salary
and bonuses followed 19% of options and 7% of LTIP and stock while from 2000 to
2005, only 40% were salary and bonuses followed by 37% of options and 23% of
LTIP and stock (Frydman; Jenter, 2010). There are three more important
components of CEO compensation labeled stealth compensation namely perquisites,
pensions and severance pay. These allow the “executives to extract rents” (Jensen
& Meckling 1976, Jensen 1986, Bebchuk & Fried 2004).

Stocks and
options are two of the five basic components of the CEO compensation. The key
difference between stock and options are “stocks give you a
small piece of ownership in the company, while options are just contracts that give you the right to buy or
sell the stock at a specific
price by a specific date” (Graham). The use of options and stocks make the
contracts convex and linear respectively. For the CEO options are riskier,”
$1 of options is worth less to
the CEO than $1 of stock” (Edmans; Gabaix, 2009) but are more expensive to the
firm. Options are cheaper for the CEO, $1 of options “provides greater
incentives than $1 of stock”. In a standard principal-agent model, where the
CEO has exponential utility and makes only an effort decision, the optimal
contract should involve only stocks and not options (Dittmann; Maug, 2007). But
these predictions are heavily contradicted. Number of recent theories prefers
options over stocks especially if the CEO has low reference wage. Options with
plausible extensions fit into the standard principal-agent problem. Options
provide “rewards for high performance” rather than “punishment for poor
performance” (Edmans; Gabaix, 2009). Options provide better risk-taking incentives
and a strong “motivator than stock if bankruptcy risk is small” (Kadan;
Swinkels, 2008). 

Managerial
myopia or short-termism is a serious problem in firms, practitioners believing “myopia
is a first-order problem faced by the modern firm” (Edmans; Fang; Lewellen,
2014). Corporate investments are long term and the future is uncertain making
it risky. “While essential for the future growth of the firm, corporate long
run investment are likely to depress earnings and cash flows in the short term”
(Salehnejad, 2017). CEOs normally take actions for short-term performance to
increase the value of the bulk of their holdings and then sell it at a high
price. A lot of surveys indicate that the CEOs are willing to sacrifice long-term
investments for short-term targets (Ladika; Sautner, 2014). In December 2004, the
Financial Accounting Standards Board (FASB) adopted FAS 123-R, “which required
all firms to begin expensing the fair value of newly granted stock options, as
well as previously granted unvested options” (Ladika; Sautner, 2014). FASB
allowed the firms to accelerate vesting before FAS 123-R took effect. Evidently,
the acceleration of options decreased long-term investments. Studies indicates that
“a 10% increase in acceleration probability due to an earlier FAS 123?R
effective date leads to an absolute decrease of 0.023 in contemporaneous industry?adjusted
capital expenditures” (Ladika; Sautner, 2014). This shows a $7.5 million decline
in investments made by a firm with total assets of $327 million. CEOs with
myopia cut investments in Research and development along with “outlays on other things that bring results in the
longer term, such as capital expenditure and advertising” (www.economist.com, 2014). “An interquartile
increase in vesting-induced equity sales is associated with a 0.25 percentage
point decline in the growth of R&D scaled by lagged total assets, which
corresponds to 4.6% of the average R&D/assets ratio, and an average decline
of $2.2 million per year”. The compensation schemes has a side effect which is excessive
risk taking. It is hard to distinguish normal risk from imprudent risk as there
is no formal definition for excessive risk (Salehnejad, 2017).

 “Another way that compensation can lead to
risk taking is through inappropriate performance measures” (Murphy, 2009). The
dramatic collapse of the JPMorgan Chase who started paying brokers who wrote
loans rather than brokers who wrote loans to borrowers that pays back. Inappropriate
performance measures can also create problems for a company.

Managerial
myopia also benefits the firm in some cases. 1. Increasing the short term value
raises the speculative component of the stock price, 2. Short-termism compels the
managers to discard short-term inefficient projects, 3. Short-termism will benefit
short-term investors, 4. Short-termism provides early feedback to the CEO (Ladika;
Sautner, 2014).

 

SOLUTION

Lengthening
the vesting period is a good solution to lengthen the executives’ horizons. Different
companies have different vesting periods. “Moreover, the vesting period can be lengthened
beyond the executives’ retirement, as suggested by equation” (Edmans; Gabaix; Jenter, 2017; p.97).
Implementing bonus-malus systems are also a good solution where the bonuses are
held by the firm and are forfeited if poor performance comes to light ” (Edmans; Gabaix; Jenter, 2017; p.98).
Both can be used to reduce imprudent risks as lengthened vesting period will
keep the rights to buy the stocks till retirement and bonus-malus systems forfeit
the held back bonuses if the firm shows poor performance.

Imprudent
risk taking can also be avoided by using inside debt or deferred compensation.
The incentives of the CEO are aligned with that of the creditors (Salehnejad id,
2017). These schemes delay a part of the CEO’s compensation by leaving it
invested in the firm at a fixed rate of return until retirement. The CEOs will
not take excessive risk as they risk losing their investment. Inside debt was
not studied in depths which lead to researchers arguing that it represents
inefficient rent extraction (Edmans, 2010; p.29). Inside debt can be optimal
for long term success as it boosts “executive motivation if bankruptcy looms on
the horizon” (Edmans, 2010; p.30).

Inside debts
have side effects if the CEOs only have limited equity making them less engaged
in firm’s future. In these type of situations, insurance giants AIG has come up
with a compensation scheme paying the CEO with debt. In this scheme, 80 percent
of the bonus is paid as firm’s bonds and 20 percent as equity (Edmans, 2010;
p.30). “This echoes recent calls to tie CEOs to the value of their bonds to
prevent future crises” (Edmans, 2010; p.30).

A high tax
on compensation will work as the more incentive the CEOs earn, more they pay.
Thus they will not be looking forward to sell the stocks soon after vesting
leading to the reduction of short-termism.

 

CONCLUSION

To conclude,
this essay has covered the controversial topic of executive compensation and
how incentives impact CEO decisions. The essay discusses the principal-agent theory,
its basic assumptions and the imperfect compensation schemes which are widely criticized.
To counter this unsound compensation schemes , my suggestions includes
lengthening the vesting period, implementing bonus-malus systems, inside debts
and paying the CEO with debt The limitation of this proposal is that the CEO
cannot control the outside forces of the economy, nature and society, and each
market have different environments.

 

INTRODUCTION

The CEO has
the highest power in a firm to make investment decisions that can affect its
performance. CEOs with no proper incentives can be risk aversive (Salehnejad,
2017a). “It’s not how much you pay, but how” (Jensen; Murphy, 1990) tell us
that mere fixed pay is not enough for the CEOs to perform on a long term basis.
It should be structured in such a way which offers both stock and options, and
fixed salary (Edmans, 2014). So an appropriate incentive has to be worked out
for the CEO for the company’s long term investments that will expand the growth
potential of the firm and increase its market value. Most of the firms
incentivizing the CEO can be understood from the fact that in the US, CEOs earn
373 times the average worker (Edmans, 2016). Imprudent risk taking should also
be avoided. Compensation schemes should be used to avoid this as these schemes
will “delay the CEO’s receipt of a certain
amount of current-year salary and bonus, leaving it invested with the firm at a
fixed rate of return until retirement or even sometime after retirement”
(Salehnejad, 2016 id). In order to create long term value, a compensation
scheme must be structured which will compel the CEO to act on their best
interests. The principal-agent problem should be solved by the optimal
structure by aligning the interests of the CEO and shareholders.

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For You For Only $13.90/page!


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PRINCIPAL-AGENT
PROBLEM

The
shareholders or principals of a firm may be too busy to manage the firm, so
they hire managers or in this case agents to manage it for them. The principal
agent problem is the difficulties that arise due to the separation of ownership
and control (Salehnejad, 2017 ls). There are certain assumptions regarding the
principal agent problem that has to be considered before developing the optimal
incentive system.

(Evidence)

Firstly, the
conflict of interests which refers to the difference in the interests of the
principal and the agent. The shareholder’s interest is the value the agent
creates while the agent’s interest is to maximize his/her earnings (Salehnejad,
2017 ls).

Second
assumption is the information asymmetries. As the shareholders are not
concentrated and dispersed that the information that the shareholders receives
on the actions of the agent are very limited. Knowledge of the shareholders
will be limited to judge the actions of the CEO. The large number of
shareholders implies there is a chance of conflicting views (Salehnejad, 2017
ls).

Third
assumption is that monitoring can be costly. Monitoring the actions of the
agent or the CEO can be challenging as it can be very costly. Appointing
“corporate boards are equally subject to agency problems” (Salehnejad, 2017
ls). Furthermore, the performance of the firm is highly dependent on the state
of the economy.

Fourth,
managers tend to be more risk-aversive than shareholders would like them to be
(Eisenhardt, 1989). The managers interest is to earn maximum incentive so all
decisions will be short termed as opposed to the long term investments in favor
of the firm. The CEO will prefer safe short term projects with low return
ratios.

Lastly, the
manager’s effort determines the firm’s revenue. The better the manager
performs, the higher the revenue the firm generates and vice-versa (Salehnejad,
2017 ls).

The shareholders
do not have the complete information regarding the CEO’s activities and the
firm’s investment opportunities, so designing a contract specifying and
enforcing the managerial action to be taken at each stage of the world is
impossible. “In these situations, agency theory predicts that compensation
policy will be designed to give the manager incentives to select and implement
actions that increase share holder wealth” (Jensen; Murphy, 1990). In addition,
an element that measures the firm’s performance independently of the firm’s
profit to ensure that the manager is not only rewarded for his efforts but also
to encourage risky investment projects should be included in an effective
system (Salehnejad, 2017).

The agent’s
total compensation will include a salary and a bonus rate. This can be
understood using a linear equation w=s+b.y, where w is the total compensation,
s is the salary, b is the bonus rate and y is the agent’s output. The variable
part of the compensation is dependent on the agent’s performance. So the basic
formula is:

S(e) = K + ??(e)6

Maximizing ?(U) = ?(S
– c(a)) is the aim of the agent where c(a) refers to the cost of action. The
optimal system would be lower the fixed salaries below the market competitive
levels and a high variable part (Murphy, 2009).

One of the
top energy company Enron went bankrupt because of the principal-agent problem. “Most of the
top executives were tried for fraud after it was revealed in November 2001 that
Enron’s earnings had been overstated by several hundred million dollars” (www.cnn.com,
2013). Apparently, Enron shares were worth $90.75 at their peak in August 2000
and dropped to $0.67 in January 2002 (www.cnn.com,
2013). There are numerous cases like the failure of Enron which displays
the severity of the principal agent problem. (Change company)

COMPENSATION
PAY SCHEMES AND INVESTMENT BEHAVIOR

Compensation
schemes are really important for aligning the interests of the principal and
the agent. The general formula for compensation schemes as shown above is S(e) = K + ??(e).

Compensation
schemes comprise of both pay structure and pay levels. The pay level refers to the amount the agent receives
and the pay structure refers to the structure of the compensation payment
(Salehnejad, 2017 ls). The
pay level was on a decline during the World War II and kept declining till late
1940s. It was in the 1970s that the CEO compensation increased rapidly and
continued until the end of the sample in 2005 with the annual growth rates reaching
more than 10% (Frydman; Jenter, 2010). Executive compensation had increased for
firms of all sizes. “For CEOs of
S&P 500 firms, the median level of pay climbed rapidly from $2.3m in 1992
to a peak of $7.2m in 2001” (Frydman; Jenter, 2010). The compensation premium of managing a larger
firm ha s increased as the growth in compensation pay is steeper in larger
firms (Frydman; Jenter, 2010). As firms tend to grow bigger, the compensation
for the CEOs also grows bigger. “If
companies become larger across the economy, the returns to employing talented
managers rise and this competition bids up wages” (Edmans; Gabaix, 2009)
forcing the principal or shareholders to formulate a balanced pay structure and
pay level.

 The
five basic components of most CEO packages are: salary, annual bonus, payout
from long-term incentive plans, restrictive option grants, and restricted stock
grants. The CEO in addition to this often receive contributions to defined?benefit
pension plans, various perquisites, and, in case of their departure, severance
payments but the relative importance of these compensation elements has changed
considerably over time. In the 1980’s, 74% of the compensation pay was salary
and bonuses followed 19% of options and 7% of LTIP and stock while from 2000 to
2005, only 40% were salary and bonuses followed by 37% of options and 23% of
LTIP and stock (Frydman; Jenter, 2010). There are three more important
components of CEO compensation labeled stealth compensation namely perquisites,
pensions and severance pay. These allow the “executives to extract rents” (Jensen
& Meckling 1976, Jensen 1986, Bebchuk & Fried 2004).

Stocks and
options are two of the five basic components of the CEO compensation. The key
difference between stock and options are “stocks give you a
small piece of ownership in the company, while options are just contracts that give you the right to buy or
sell the stock at a specific
price by a specific date” (Graham). The use of options and stocks make the
contracts convex and linear respectively. For the CEO options are riskier,”
$1 of options is worth less to
the CEO than $1 of stock” (Edmans; Gabaix, 2009) but are more expensive to the
firm. Options are cheaper for the CEO, $1 of options “provides greater
incentives than $1 of stock”. In a standard principal-agent model, where the
CEO has exponential utility and makes only an effort decision, the optimal
contract should involve only stocks and not options (Dittmann; Maug, 2007). But
these predictions are heavily contradicted. Number of recent theories prefers
options over stocks especially if the CEO has low reference wage. Options with
plausible extensions fit into the standard principal-agent problem. Options
provide “rewards for high performance” rather than “punishment for poor
performance” (Edmans; Gabaix, 2009). Options provide better risk-taking incentives
and a strong “motivator than stock if bankruptcy risk is small” (Kadan;
Swinkels, 2008). 

Managerial
myopia or short-termism is a serious problem in firms, practitioners believing “myopia
is a first-order problem faced by the modern firm” (Edmans; Fang; Lewellen,
2014). Corporate investments are long term and the future is uncertain making
it risky. “While essential for the future growth of the firm, corporate long
run investment are likely to depress earnings and cash flows in the short term”
(Salehnejad, 2017). CEOs normally take actions for short-term performance to
increase the value of the bulk of their holdings and then sell it at a high
price. A lot of surveys indicate that the CEOs are willing to sacrifice long-term
investments for short-term targets (Ladika; Sautner, 2014). In December 2004, the
Financial Accounting Standards Board (FASB) adopted FAS 123-R, “which required
all firms to begin expensing the fair value of newly granted stock options, as
well as previously granted unvested options” (Ladika; Sautner, 2014). FASB
allowed the firms to accelerate vesting before FAS 123-R took effect. Evidently,
the acceleration of options decreased long-term investments. Studies indicates that
“a 10% increase in acceleration probability due to an earlier FAS 123?R
effective date leads to an absolute decrease of 0.023 in contemporaneous industry?adjusted
capital expenditures” (Ladika; Sautner, 2014). This shows a $7.5 million decline
in investments made by a firm with total assets of $327 million. CEOs with
myopia cut investments in Research and development along with “outlays on other things that bring results in the
longer term, such as capital expenditure and advertising” (www.economist.com, 2014). “An interquartile
increase in vesting-induced equity sales is associated with a 0.25 percentage
point decline in the growth of R&D scaled by lagged total assets, which
corresponds to 4.6% of the average R&D/assets ratio, and an average decline
of $2.2 million per year”. The compensation schemes has a side effect which is excessive
risk taking. It is hard to distinguish normal risk from imprudent risk as there
is no formal definition for excessive risk (Salehnejad, 2017).

 “Another way that compensation can lead to
risk taking is through inappropriate performance measures” (Murphy, 2009). The
dramatic collapse of the JPMorgan Chase who started paying brokers who wrote
loans rather than brokers who wrote loans to borrowers that pays back. Inappropriate
performance measures can also create problems for a company.

Managerial
myopia also benefits the firm in some cases. 1. Increasing the short term value
raises the speculative component of the stock price, 2. Short-termism compels the
managers to discard short-term inefficient projects, 3. Short-termism will benefit
short-term investors, 4. Short-termism provides early feedback to the CEO (Ladika;
Sautner, 2014).

 

SOLUTION

Lengthening
the vesting period is a good solution to lengthen the executives’ horizons. Different
companies have different vesting periods. “Moreover, the vesting period can be lengthened
beyond the executives’ retirement, as suggested by equation” (Edmans; Gabaix; Jenter, 2017; p.97).
Implementing bonus-malus systems are also a good solution where the bonuses are
held by the firm and are forfeited if poor performance comes to light ” (Edmans; Gabaix; Jenter, 2017; p.98).
Both can be used to reduce imprudent risks as lengthened vesting period will
keep the rights to buy the stocks till retirement and bonus-malus systems forfeit
the held back bonuses if the firm shows poor performance.

Imprudent
risk taking can also be avoided by using inside debt or deferred compensation.
The incentives of the CEO are aligned with that of the creditors (Salehnejad id,
2017). These schemes delay a part of the CEO’s compensation by leaving it
invested in the firm at a fixed rate of return until retirement. The CEOs will
not take excessive risk as they risk losing their investment. Inside debt was
not studied in depths which lead to researchers arguing that it represents
inefficient rent extraction (Edmans, 2010; p.29). Inside debt can be optimal
for long term success as it boosts “executive motivation if bankruptcy looms on
the horizon” (Edmans, 2010; p.30).

Inside debts
have side effects if the CEOs only have limited equity making them less engaged
in firm’s future. In these type of situations, insurance giants AIG has come up
with a compensation scheme paying the CEO with debt. In this scheme, 80 percent
of the bonus is paid as firm’s bonds and 20 percent as equity (Edmans, 2010;
p.30). “This echoes recent calls to tie CEOs to the value of their bonds to
prevent future crises” (Edmans, 2010; p.30).

A high tax
on compensation will work as the more incentive the CEOs earn, more they pay.
Thus they will not be looking forward to sell the stocks soon after vesting
leading to the reduction of short-termism.

 

CONCLUSION

To conclude,
this essay has covered the controversial topic of executive compensation and
how incentives impact CEO decisions. The essay discusses the principal-agent theory,
its basic assumptions and the imperfect compensation schemes which are widely criticized.
To counter this unsound compensation schemes , my suggestions includes
lengthening the vesting period, implementing bonus-malus systems, inside debts
and paying the CEO with debt The limitation of this proposal is that the CEO
cannot control the outside forces of the economy, nature and society, and each
market have different environments.

 

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