CORPORATE (presentatio)

8/7/2019 CORPORATE (presentatio)

1/26

CORPORATEGOVERNANCE AND

MANAGERIAL

COMPENSATION

Presented byPresented by

Anum andAnum and KomalKomal


2/26

INTRODUCTIONINTRODUCTION

This chapter isThis chapter isabout managerialabout managerialcompensation system.compensation system.

major responsibility ofmajor responsibility ofBOD is to determineBOD is to determinehow to compensatehow to compensatepeople.people.


3/26

Major Responsibility of BODMajor Responsibility of BOD

Important Questions

How should managers be compensated?

Should pay be tied to performance?

How should performance be measured? What evidence is there about the relation between

managerial pay and performance?

What pay, performance evaluation, andcompensation systems are likely to mitigate and

conflicts of interests between managers andshareholders?


4/26

The problemThe problem

Problem is that owners can notProblem is that owners can notwatch directly to managers andwatch directly to managers andmanagers often have moremanagers often have more

information then owners soinformation then owners soowners can evaluateowners can evaluateperformance of managers ?performance of managers ?

Solution:Solution:

One way to deal with thisproblem is to tie the managerscompensation entirely to anoutput measurelets sayprofits.


5/26

MEASURING EFFORT AND

PERFORMANCE

For measuring performance andFor measuring performance andefforts of managers there are twoefforts of managers there are twotoolstools

Measuring inputs( number of hoursMeasuring inputs( number of hoursa manger spent on his job ,costsa manger spent on his job ,costsof materials and processing)of materials and processing)

Measuring outputs (profits, ROI,Measuring outputs (profits, ROI,ROA, ROE & share price).ROA, ROE & share price).

For measuring performance ofFor measuring performance ofmanagers there should be amanagers there should be acomparison of inputs and outputs.comparison of inputs and outputs.


6/26

Separation of management effortSeparation of management effortand other factorsand other factors

management makes to performance from factors that arenot under management control (luck, noise) remains.

How do we get out of this box?

Measures of relative performance may be one

answerOwners can measure managerial performance relative to the

performance of other firms in the industry or some other

benchmark


7/26

Separation of management effortSeparation of management effortand other factorsand other factors

Suppose the per share price of XYZCorporation fell by 8 percent over the year.

Was the decline in the share price due to poormanagement or to factors beyond thecontrol of management, such as aneconomy wide recession?


8/26

COMMON PAY AND PERFORMANCE

SCHEMES

In the United States, seniormanagers pay typically hasthree components:

a fixed or base salary,

a short-term or annual bonuspayment,

a long-term bonus orperformance payment.


9/26

Base Salary Examples

Base salaries for senior managers are set bythe compensation committee of theboard of directors.

. the base salary of the CEO based on The CEOs base salary the previous

year,

Increased responsibilities,

The CEOs past performance.


10/26

Short-Term Incentive Plans

Short-term (annual) incentive pay plans tie aportion of managerial pay to the performance ofthe company over the past year; hence the term

annual incentive plans.

These plans consist of performance measures,individual and group standards or goals.


11/26

Short-Term Incentive Plans

Performance measures for short-term incentive plans almost

always include one or more financial statement metrics.

Typically, some measure of accounting income is used, such

as earnings before interest and taxes (EBIT), net incomebefore taxes, net income after taxes, and or earnings per

share.

In addition to levels of income, rates of return on assets,stockholders equity, or sales may also be used. Occasionally,

rates of growth in sales or income may be included as well


12/26

Problems with Short-Term IncentivePlans

Short-term incentive plans do not alwaysalign the interests of managers with thoseof the public shareholders

Problems arise because accountingmeasures are used, because performancestandards can be manipulated

managers can game the system bytransferring effort from one period toanother.


13/26

Problems with AccountingMeasures

Therefore, managerscanmanipulate netincome by reducingexpenditureson

suchthingsasadvertising, researchanddevelopment, and employee trainingprogramsinordertoearn higherbonuses

underashort-termaccounting-basedincentive scheme


14/26

ProblemswithBudgets

A secondimportant facttorememberaboutaccounting

profitsisthatmanagerscan manipulate themtomoveprofits fromone accountingperiodtothe next.

Exampleswouldinclude the choice ofdepreciationschedules forassets, accrualsof expenses, andbookingofrevenues. Indeed, managerscommonly use discretionaryaccountingrulestosmoothearnings fromone yeartothe

nextin ordertoavoidreportinglarge one-time gainsorlossesin income. Thus, managerscan game bonusplansthroughmanipulatingaccountingearnings.


15/26

Potential Gaming BehaviorPotential Gaming BehaviorFinally, the thresholds and caps on shortFinally, the thresholds and caps on short--term plans can alsoterm plans can alsoinduce managerial gaming.induce managerial gaming.

Suppose a manager receives a bonus ofSuppose a manager receives a bonus of 2020 percent of basepercent of basesalary if net income for the year is greater than $salary if net income for the year is greater than $100100 million,million,and the bonus rises toand the bonus rises to 2525 percent if net income is $percent if net income is $150150million. No additional bonus is paid if net income exceedsmillion. No additional bonus is paid if net income exceeds$$150150 million.million.

If the likelihood that net income for the year will reach $If the likelihood that net income for the year will reach $100100million is nil, she has no incentive to exert additional effortmillion is nil, she has no incentive to exert additional effort

for that year. She faces the same incentive if net income isfor that year. She faces the same incentive if net income islikely to be above $likely to be above $150150 million.million.

As She receives no additional bonus this year for income overAs She receives no additional bonus this year for income over$$150150 million, so, again, why not book expenses this yearmillion, so, again, why not book expenses this year

and delay sales until next yearand delay sales until next year??


16/26

why are the plans shortwhy are the plans short--termterm

plans so common?plans so common?Accounting numbers are verifiable and are calculatedAccounting numbers are verifiable and are calculatedaccording to a set of generally accepted rules.according to a set of generally accepted rules.

Managers know the rules and can predict the effects of theirManagers know the rules and can predict the effects of theirbehavior on their pay.behavior on their pay.

So, managers can focus their attention on those metrics thatSo, managers can focus their attention on those metrics that

those who design the plans believe are important forthose who design the plans believe are important formaximizing shareholder wealth and not worry about aftermaximizing shareholder wealth and not worry about after--thethe--fact reinterpretations of performance being used tofact reinterpretations of performance being used to

change the rules of the gamechange the rules of the game..


17/26

LongLong--Term Incentive PlansTerm Incentive Plans

LongLong--term incentive plans tie a portion ofterm incentive plans tie a portion ofmanagerial pay to some longmanagerial pay to some long--termtermperformance measure, evaluated over moreperformance measure, evaluated over more

than one year.than one year.The bonuses may be paid in cash, restrictedThe bonuses may be paid in cash, restrictedstock, or stock options.stock, or stock options.Restricted stockRestricted stock

is a grant of shares in theis a grant of shares in thecompany that may not be sold or disposed ofcompany that may not be sold or disposed ofprior to a future date and that may be forfeitedprior to a future date and that may be forfeitedif the manager leaves before the end of theif the manager leaves before the end of therestricted period.restricted period.


18/26

DEFINATIONS

The stock optionThe stock option is a financial contract thatis a financial contract that

gives the owner the right but not the obligationgives the owner the right but not the obligation

to buy or sell stock at a specified price, calledto buy or sell stock at a specified price, calledthe strike or exercise price, through a specifiedthe strike or exercise price, through a specified

period of time, called the options expirationperiod of time, called the options expiration

date.date.

A call optionA call option is the right to buy stock;is the right to buy stock;

A put optionA put option is the right to sell the stock atis the right to sell the stock at

the strike pricethe strike price..


19/26

Determinants of an options valueDeterminants of an options value

The difference between the strike price andThe difference between the strike price andthe market price of the stock.the market price of the stock.

For a call option (which is what managers receive), theFor a call option (which is what managers receive), theoption becomes more valuable as the market price ofoption becomes more valuable as the market price ofthe stock rises above the strike price.the stock rises above the strike price.

The other important determinant is the volatilityThe other important determinant is the volatilityof the stock price.of the stock price.

The more volatile the stock price, the moreThe more volatile the stock price, the morevaluable the option.valuable the option.

The way to increase stock price volatility is to makeThe way to increase stock price volatility is to makemore risk investments.more risk investments.


20/26

Restrictions under longRestrictions under long--termterm

incentive programsincentive programsThe options cannot be exercised immediately but must beThe options cannot be exercised immediately but must beheld for a specified number of yearsheld for a specified number of yearsa process calleda process calledvesting.vesting.

The options cannot be sold, and if the manager leaves theThe options cannot be sold, and if the manager leaves thefirm before the vesting period, the options are voided.firm before the vesting period, the options are voided.

Other conditions can also be placed on the stock optionOther conditions can also be placed on the stock optiongrants, such as mandating that the stock price must reachgrants, such as mandating that the stock price must reacha certain level before the options are given to thea certain level before the options are given to themanager.manager.


21/26

Problems with Stock Option andProblems with Stock Option and

Restricted Stock PlansRestricted Stock PlansExecutives who hold stock options do not receive cash dividends.Executives who hold stock options do not receive cash dividends.Therefore, these executives may be inclined to retain earnings ratherTherefore, these executives may be inclined to retain earnings ratherthan return them to the public shareholders.than return them to the public shareholders.

Alternatively, managers may prefer to repurchase the companys stockAlternatively, managers may prefer to repurchase the companys stockrather than distribute the cash to shareholders as cash dividends.rather than distribute the cash to shareholders as cash dividends.

Another potential problem with stock options and restricted stock is thatAnother potential problem with stock options and restricted stock is thatmanagers may take on very risky investments if the stock price hasmanagers may take on very risky investments if the stock price has

fallen or if the stock price goals under a restricted stock plan appearfallen or if the stock price goals under a restricted stock plan appearunlikely to be met.unlikely to be met.

The most visible problems with using options to compensate managersThe most visible problems with using options to compensate managersthat have surfaced involve earnings and earnings manipulation.that have surfaced involve earnings and earnings manipulation.


22/26

epor e arn ngs an ay ngepor e arn ngs an ay ngManagers with Stock or StockManagers with Stock or Stock

OptionsOptionsShould the value of the options granted management beShould the value of the options granted management berecorded as an expenserecorded as an expensein the same way that salaries arein the same way that salaries arean expensean expenseand thereby result in a lowered net incomeand thereby result in a lowered net incomeand earnings per share?and earnings per share?

The argument for recording options and restricted stock as anThe argument for recording options and restricted stock as anexpense is that these grants, if exercised or vested, willexpense is that these grants, if exercised or vested, willcause the claims of existing shareholders on the assets,cause the claims of existing shareholders on the assets,

cash flows, and earnings of the company to be dilutedcash flows, and earnings of the company to be diluted..


23/26

Abusive Manipulation of EarningsAbusive Manipulation of Earnings

Most larger problem is abusive earnings manipulationsMost larger problem is abusive earnings manipulationslegallegaland illegal.and illegal.

One way is to simply prohibit pay schemes such as stockOne way is to simply prohibit pay schemes such as stockoptions so as to remove the temptations of managers tooptions so as to remove the temptations of managers tomanipulate earnings. But then the benefits of thesemanipulate earnings. But then the benefits of theseschemes are also lost.schemes are also lost.

Another way is to reform the rules and institutions forAnother way is to reform the rules and institutions forauditing the books of publicly held corporations, includingauditing the books of publicly held corporations, includingthe responsibilities and legal accountability of managersthe responsibilities and legal accountability of managersand auditors.and auditors.


24/26

EVA: a very popular compensation planEVA: a very popular compensation planand corporate governance metricand corporate governance metric

EVA stands for Economic Value Added and is a trademarkedEVA stands for Economic Value Added and is a trademarkedproduct of Stern Stewart & Company. we use EVAproduct of Stern Stewart & Company. we use EVA

As a vehicle for explaining how corporate boards are trying toAs a vehicle for explaining how corporate boards are trying toconnect managerial pay to performance and align the interests ofconnect managerial pay to performance and align the interests of

managers with those of public shareholders.managers with those of public shareholders.

To improve our understanding of risk and return tradeoffs.To improve our understanding of risk and return tradeoffs.

Used by investment bankers, for valuing companies around theUsed by investment bankers, for valuing companies around theworld.world.


25/26

EVA VS. NPVEVA VS. NPV

NPV as the difference between the present value of the expected afterNPV as the difference between the present value of the expected after--tax cash flows from an investment project and the present value of thetax cash flows from an investment project and the present value of thecash outflows invested in the project, both discounted at the projectscash outflows invested in the project, both discounted at the projects

cost of capital.cost of capital.

The greater the NPV, the better the project with respect to creatingThe greater the NPV, the better the project with respect to creatingshareholder wealth and increasing the stock price.shareholder wealth and increasing the stock price.

The greater the NPV, the greater the marketThe greater the NPV, the greater the market--toto--book ratio.book ratio.

EVA is simply a way of measuring whether managers have been ableEVA is simply a way of measuring whether managers have been ableto undertake positive NPV projects and earn a return for theto undertake positive NPV projects and earn a return for the

shareholders that is greater than the investors required rate of returnshareholders that is greater than the investors required rate of returnon the stock.on the stock.


26/26

THANKYOUTHANKYOU

CORPORATE (presentatio)

Documents

Transcript of CORPORATE (presentatio)