Firm’s financialperformance is largely depending on investment decisions made by topmanagement. Corporate long run investments in new projects are essential forthe future growth of the organisation but they are likely lead to thedepression of cash flow and earnings in the short term. Managers may undertakemyopic actions that increase stock price temporarily and exploit it byexercising vested options and selling equity for their own good (Ladika & Sautner, 2013). Therefore, there is a need foran effective pay contract or compensation pay scheme to capture mangers’incentives and shape their behaviors, which ensures managers put forth theirbest effort according to their best interest. The connection between incentivesystems and investment decisions is related to principal agent problem and theoptimal solution is to align the interest of shareholders and CEOs. To ensurethe long run growth of the firm, ideally, the CEO should take risky decisionsbut not engage in excessively risky decisions. The objective of the essay is toexplore the how the compensation pay contract can be design to encourage the CEOtaking risky decision but avoiding imprudent decisions.
This essay willfirstly demonstrate principal agent theory and its underlying assumptions;then, the next session will discuss various compensation pay scheme at a deeperlevel; The next session refers to critically examine compensation pay schemeand find optimal solutions; Finally, conclude the essay. PRINCIPAL-AGENTPROBLEM& THE GENERAL SOLUTION:Principle-Agentproblems arises from the separation of control and ownership betweenshareholders and managers that have different interests (Baye andPrince, 2017). Before propose the general solution, theessay will introduce the assumptions of principle agent theory as follows: The first assumption isthat there is a separation of ownership and control in agency theory.
Best services for writing your paper according to Trustpilot
Largecorporations are owned by many shareholders so that no single shareholdersreally have the power to control the behaviors of the managers of thecorporation. In situation like this, the interests of the managers and theshareholders can be diverged widely (Salehnejad, 2017a). The managers maypursue the maximization of their benefits such as power, reputation, wealth oreven leisure, and they work in an environmental and institutional context thatmany external factors (company law, auditing, public opinion) should beconsidered (Baye and Prince, 2017).
On the other hand,the shareholders may be only interested in profits maximization of the firm.Briefly, there is a conflict of interest between the shareholder and managersand senior managers may exploit their positions to pursue benefits at theexpense of long-run growth of the firm (Baye and Prince, 2017). The second assumptionunderlying the firm’s revenue depending on managers efforts. The higher iseffort, the higher is the profit.
The essence of the problem is that themanager likes to earn incomes but also consume leisure. Clearly, if the managerspends every waking hour on the job, he will not be able to consume any leisure.Consequently, without adequate rewards the manager is likely to minimise hisefforts and choose consuming efforts (Salehnejad, 2017a).
The third is connectedto asymmetric information, which means managers have more information aboutthemselves than shareholders have. This leads to the moral hazards situationwhere shareholders are not able to observe the hidden actions of managers in anefficient or feasible way (Baye and Prince, 2017).In addition, even all actions of the manager are observable, shareholders maynot have the expertise to judge whether the manager’s actions are in line withtheir best interest due to high dispersion of shareholders and the lack ofknowledge (Abdalla, 2008). Besides asymmetric information, the uncertainty ofthe future income also adds the difficulty to examine managers’ performance (Salehnejad,2017a). The firm are subject to uncertain conditions such as depression andprofits may be low even if mangers make the most appropriate investmentdecisions for the firm.
It is hard to determine whether the manager has spenthis best efforts simply by observing firm’s profits. The last assumption isthat shareholders tend to be less risk-averse than managers. By investing inmultiple corporations and unrelated market, shareholders may be able todiversify their risk (Salehnejad, 2017a).. Incontrast, the manager only operates in one company and his income reliesheavily on the company’s profits.
In addition, his skills and knowledge may belimited to a specific firm or industry, which makes it harder for them to takethe risky decision which may yield high profits (Hovenkamp, 2009). This leadsto another conflict of interest: managers prefer short-run projects with safetybut low returns while shareholders prefer long-run projects with high risk buthuge profits. It was reported in 2001that the new CEO of 3M corporation, James McNerney, dropped the 30% rules whichmeasures divisional manager’s performance through computing what fraction ofthe products are new to this year. Managers used to be under this rule hadlittle incentives to innovate products and from 1995 to 2000 the firm’s stockprice lagged it the average of S (Hymowitz, 2002).This is a typical example of principal-agent problem which the interest ofdivisional managers did not align with the frim. It is important for the firmto find the right incentives for the manager and compensation pay contract may bea general solution to this problem. Due to the conflictinterest between different managers and shareholders, there is a need to setcompensation varied with company’s overall profits to which is a floated salary(??(e)), so that managers’ interest isin line with shareholders’. On the other hand, due to the uncertainty of thestate of the economy, the profit of company is unstable and risky.
A fixedsalary(K) should be introducedindependently to incentivize managers to be less risk-averse and to pursepromising risky investment projects. In fact, it is suggested that the fixedsalary should be below market competitive levels as (Murphy, 2009). Theresulting formula is as follows: S(e) = K + ??(e)However, the conceptualmodel only considers few factors and in the real world many variables are atplay (Salehnejad, 2017a). COMPENSATION PAYSCHEMES& INVESTMENT BEHAVIOUR:There are many debateson the level and structure of CEO compensation.
The level of CEO’s pay has beenincreasing dramatically over decades. Frydman (2010)documented that the total salary of CEO in US large companies has surged byfive times in the last 30 years. On one hand, the high level of CEO pay is seenas the results of executives’ ability to set their own pay and extract rentfrom firms they manage, which is due to the weak corporate governance andacquiescent board. This can result in inefficiently high level of compensationand managers may take decisions that can only increase their pay but fail toalign the interests with shareholders. (Bebchuk and Fried, 2004). On theother hand, a growing literature argues that the growth in CEO pay is theefficient result of rising demand of CEO effort or scarce managerial talent. Ifhigher talent CEO is more valuable in larger firms, then larger firms shouldoffer higher levels of pay so that they can be matched with more capable CEO (Rosen 1981, 1982).
In addition, Frydman(2005) and Murphy and Zabojnik(2007) analyzed that rise of CEO pay are resulting from the increasing importanceof transferable rather than human- specific capital for the CEO’s job, whichraises pay directly through expanding CEO’s outside options. The rise of thepossibility of switching job may induce CEOs to select short-term to increasetheir external marketability, which aggravates the conflict of the interestbetween managers and shareholders. In a nutshell, it is not the high level ofCEO pay that has impact on the investment decisions, it is the reasons behind thephenomenon that could induce CEOs to be behave myopically. As for the structure ofpay, most compensation schemes include fixed salary, annual bonus, long termincentive plan(LTIP), RSU and stock options.
Since 1980s the proportion ofstock option, share, and LTIP compensation started surged, and by 2005 them madeup to 60% of the total CEO pay (Frydman& Jenter, 2008, p. 7). The relativeimportance of these compensation elements has changed considerably overtime, andtoday’s bonuses were tied to one or more measures of annual accountingperformance and paid in either cash or stock (Frydman& Jenter, 2008, p. 6). Stock and options areincentives to motivate managers to take appropriate investment decisions. However,they differ along two dimensions Since options are risker, $1 of options isworth less to the CEO than $1 of stock, making them more expensive to the firm.
On the other hand, because the options will have value only if the stock pricerises after the options are granted, $1 of options provides greater incentivesthan 1$ of stock (Gabaix and Edmans, 2009). Typically, optionsgive the CEO the right but not the obligation to purchase or sell a givennumber of share at a certain level of price at some future data (Berk, 2014, p. 707). Options may be an efficient way to incentive the CEO asthe options are close to worthless if the stock price won’t rise. However, whenit comes to vesting period, it can be hard for the CEO to improve the company’sperformance by opening new markets or developing new products in a shortperiod.
To boost the stock price, the CEO may use short-term techniques andcuts R, advertising, and capital expenditure at the expense of the futuregrowth of the company, which leads to managerial myopia (Edmans, Fangand Lewellen, 2013). Studyfound that having shorter investing period may increase the chance of short-termism(managerial myopia), causing managers reducing their horizon to short termprojects and selling their boosted options before long-term cost of his myopicdecision is realized (Ladika & Sautner, 2013).Researchers found that a 10% deduct in the vesting periods of the CEO’s stockoption grant caused a decrease of 0.023 in capital expenditure (Ladika & Sautner, 2013). In addition, anothersurvey indicates that an interquartile increase in vesting-induced equity salesrelates to a 0.25% decline in the growth of R&D and an average decline of$2.2 million per year (Edmans, Fangand Lewellen, 2013). On the other hand, the CEOmay be concerned with the firm’s shorter stock price for various reasons.
Hemay be under the pressure of CEO’s performance assessment that is throughjudging short-term stock price, which can also lead to short-termism (Edman et al,2014). In conclusion, themajor problem of the current payment scheme is that it induces CEOs to beshort-termism, reducing in R&D, advertising, capital expenditure at theexpense of long-run growth. In addition, managers experience no reduction inreal wealth if the stock price decreases, which allows managersto take excessively risky decisions with no actual penalties (Salehnejad,2017c). Standard stock option grants do not entirely achieve the objective.There is a need for corporate boards and shareholder to design a compensationcontract and governance mechanisms that motivate CEOs to focus on long termfurther growth and avoid excessively risky decisions.SOLUTIONS:From the point ofEdmans (2009) view, there are main two problems in existing schemes.
First,stock and option have shorts vesting periods, allowing CEO to cash out earlyand liquidate their holdings before the long-run cost is realized. Oneprinciple (long-horizon principle) for the optimal solution is that thelong-term incentives must be provided for executives to maximise long-termvalue. Second, existing schemes fail to keep up with firm’s changingconditions. Stock and options will have little incentive effect to the managerif the firm’s stock price plummets. Another principle (constant percentagechange principle) is that the percentage change of pay is varied with thepercentage change of the firm’s value, and the appropriate proportion should bebased on their industry and life cycle (Gabaix and Edmans, 2009).Researchers suggest that incentive accounts can be a possible solution to theseproblems – rebalancing and gradual vesting to satisfy the long-horizonprinciple.
If the share price falls, managers will be required to hold moreequities than with a reduction in cash of his pay to maintain incentives, whichalso rewards CEO for failure. Each month, a fixed fraction of the incentiveaccount vests and full vesting will occur only after several years from leavingthe firm. Since the manager has great wealth connected the firm’s value afterhis departure, he has little incentives to focus on short-term investmentprojects or manipulating earnings.
The drawback of gradual vesting is that itraises cost. Managers may require a higher salary as a compensation due to therisk imposed on them. As for implication, gradual vesting can be enhanced byadding benchmarking to market performance to ensure rewards are not for luck. Inside debt is anotherproposal especially for highly leveraged firms such as investment banks. Thisproposal emphases on solving the imprudent risk-taking and tires to linkcompensation to firm risk. It refers to delay the CEO’s receipt of a certainamount of current-year salary and bonus, leaving it vested in the firm at afixed rate of return and until retirement or even after retirement(Salehnejad,2016a).
It has been argued that inside debt aligns the interests of the CEOwith both shareholders and creditors and prevent the CEO take excessively riskydecisions. Some empirical evidences have supported the use of inside debt. Astudy by Tung and Wang (2010) reported that bank CEO’s with higher level ofinside debt compensation reduced firm’s risk and thus performed better duringthe subprime financial crisis. Edmans (2009) also adds that debt compensationcan be an optimal element in CEO pay, particularly when a company facesfinancial difficulties. However, Bebchuk and Jackson have argued that debtrepresents inefficient rent extraction, as the executives take advantages oflimited disclosure rules to pay themselves high pensions.
As disclosure of debtcompensation has been extremely limited, debt compensation is not the positionof commonplace. Severance pay involves rewardingCEOs for failure and has been particularly controversial in compensation in therecent financial crisis (Yermack, 2006). Manso (2008) shows that if animportant aspect of the CEO’s job is to develop new technologies rather thanexploit existing ones, rewarding for the failure can be the optimal feature inthe compensation schemes. On the other hand, it been argued that severance payis difficult to rationalize with a standard principal-agent model, as the CEOsonly control efforts (Edmans and Gabaix, 2009).Furthermore, the CEO may fail to spend effort with long- lasting consequencesas he fears dismissal if the board is strong (Almazan& Suarez, 2003). CONCLUSION:As there are severalproblems of current compensation schemes, different solutions came up withemphasis on different issues.
Firms’ value is subject to changing conditionsand stock price may decline. To smooth the effect on incentives for themanagers and to induce mangers long-term focused behaviours, optimal contractcan involve the Incentive account. However, this solution can be costly to thefirm and in application it should be accompanied by other features to ensurethe fair performance assessment of the CEO. To avoid mangers taking excessivelyrisky decisions when the firm faces difficulties and to align interest of theCOEs with shareholders and creditors, inside debt can be an efficient tool toreduce firm risk and ensure managers perform better. On the other hand, debtrepresents inefficient rent extraction and disclosure of debt compensation hasbeen extremely limited, which is not commonly accepted by executives. Severancepay is efficient when the firm is exploring new technology as the manager isrewarded for the failure.
However, it has been reported that severance pay candeter the CEO from entrenching himself by hiding negative information that maylead to his dismissal. In a nutshell, there is no single optimal compensation schemesfor all cases and different solutions should be assigned with differentsituations.
