Chapter 2

Executive
Incentives
 Chapter overview
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

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 Potential Managerial Temptations

A good manager should put the needs of

other stakeholders before his own.

However, if shareholders cannot effectively

monitor managers’ behavior, then managers
may be tempted to put his needs first, even
at the expenses of shareholders.

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 Examples of Self-serving Managerial
Actions

Shirking (i.e. not working hard)

Hiring friends
Consuming excessive perks
Building empires
Taking no risks or chances to avoid being
fired
Having a short-run horizon if the managers is
near retirement

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 Types of Executive Compensation

Base Salary and Bonus

The base salary is usually determined through
the benchmarking method.
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.
Comparison of awarding bonuses with giving
large raises.

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 Types of Executive Compensation
(continued)

Stock Option
Executive stock options—the most common
form of market-oriented incentive pay.
Stock options give the executive of the firm the
incentive to manage the firm.
Stock options are believed to align managers’
goals with shareholders’ goals.
Stock options have asymmetric incentives
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 Stock Option

Options and Accounting

Stock option’s favorable tax treatment for
both the executive and the company
Accounting cost and economic cost
FAS 123(R)

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 Types of Executive Compensation
(continued)

Stock Grants
—An alternative form of long-term incentive
compensation that avoids governance failure
• Restricted stock does not have asymmetric
incentives
• Performance shares can be viewed as
bonuses for past realized performance.

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 Does Incentive-based Compensation
Work in General?

Two ways to examine the efficacy of

incentive-based compensation:
ex post evidence, pay-for-performance sensitivity
ex ante evidence

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 Potential “Incentive” Problems with
Incentive-based Compensation

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

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 Problems with Stock Option Incentives

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

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 Another Problem with Executive Stock
Options

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

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 Real-World Examples

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

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 Example: Xerox Corporation
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Xerox executives sell $48 million worth of
options and $31 million in other stock.
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X e ro x S to c k P ric e ($ )

50

40

30

20

10
period of phony profits

0
J an-90

J an-91

J an-93

J an-94

J an-95

J an-96

J an-97

J an-98

J an-99

J an-00

J an-01

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 Expensing Executive Options:
An Easy Solution?

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
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 Other Compensation

Club membership, financial advisors, luxury

cars and chauffeurs, personal travel, etc.
Retirement compensation
Company loan

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 Crime and Punishment

An alternative way to solve the agency-

problem is to increase the penalty
The new Sarbanes-Oxley Act

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 18
Percent of Total Pay

100%

0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Fixed Pay
Perquisites

Variable Pay
Argentina

Australia

Belgium

Brazil

Canada

China-Hong Kong

China-Shanghai

France

Germany

India

Italy

Japan

Mexico

Netherlands

Singapore

South Korea

Spain
International Perspective-CEO

Sweden

Switzerland
Compensation Around the World

Taiwan

United Kingdom

United States

Venezuela
 Summary

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.

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