Week2 Agency Compensation
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Transcript of Week2 Agency Compensation
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7/23/2019 Week2 Agency Compensation
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in hole or in part.
Agency Problems and Executive
Compensation
Corporate Finance, 3eGraham, Smart, and Megginson
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The Main Participants in a irm
Shareholdersof the rm who holdresidual claim to all the cash ows ofthe rm.
Limited liabilityManagerswho control the day-to-day
operations of the rm.
Firm employees but not ownersBondholderswho have a prior but
xed claim to cash ows of the rm.
No decision-making participation 2 - 2
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The Main Participants! Goals
Shareholders !ypically hold diversied portfolios" so only face systematic risk
#beta$
Long-term investment hori%ons
&eek stock price maximi%ation
Managers 'ay not hold a diversied portfolio" so face systematic as well
as non-systematic risk
&hort-term income earning hori%on( value )ob security *+ort level lower than if , entrepreneurial ownership
/er0uisite consumption
'ay get entrenched make their own position secure at theexpense of investors
Bondholders: &tand to lose if the rm goes bankrupt
1ould like to minimi%e risk once bonds are purchased
2 - 3
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Shareholder " ManagerCon#icts 2wnership 3 4ontrol separation
&hareholders expect managers to act intheir best interest
4ollective action problem too expensive forindividualshareholders to constantlymonitor the actions of managers whilesharing the benets
Free-rider problem owners rely on thee+orts of others to monitor the company *xternal auditors #*nron and 5rthur 5ndersen$
6anks
&olutions are costly 2 - 4
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Shareholder " $ondholderCon#icts
!he market value of any rm e0uals the marketvalue of its bonds plus the market value of itsstock
% & ' ( E
&hareholders have limited liability and the choiceto turn the rm7s assets over to its creditorsinstead of repaying!his optionbecomes more valuable as company cash
ows are more volatile
8f ownership transfer were costless" bondholders wouldbecome the new shareholders of the rm without loss ofvalue
4eteris paribus" the value of e0uity rises 9 and
the value of debt declines 9 in line with the 2 - 5
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Shareholder " $ondholderCon#icts
:ltimately" increasing the risk of the rmredistributes wealth from bondholders tostockholders.!he risk of default has increased but bondholders are not
compensated for the added risk
Firm can issue additional debt
5ll else e0ual" therefore" shareholders have anincentive to engage in risk-increasing activities#e.g." highly risky pro)ects$ that have the potential
of big returns. Limited downside but unlimited upside potential
8f the investments pay o+" the shareholders havea high return( if the investments are unsuccessful"
the bondholders will bear most of the costs. 2 - 6
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Shareholder " $ondholderCon#icts
6ondholders may anticipate these agencyproblems and demand a higher returnbecause of thepossibilityof opportunisticbehavior.
6ondholders may also re0uire certainrestrictive covenantsin bond contracts
which limit the types of actions managerscan take.
!hese are examples of the agency costs of2 - 7
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Ma)ority Shareholder "Minority Shareholder Con#icts
'inority shareholders could also faceexpropriation like creditors
4orporate governance mechanisms
should be in place to provideprotection4ould result in more disperse stock
ownership'a)ority shareholders may alter rm
investment policy
/et pro)ects" etc.
2 - 8
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Compensation* Stoc+ ptions
&tock options are usually issued at-the-money.!here is a vesting period before they can beexercised. 8f the employee leaves during thistime" the options are forfeited.
8f employees leave after the vesting period" in-the-money options are exercised immediately andout-of-the money options are forfeited. 2ptionsare not transferrable.
1hen options are exercised" the number of sharesoutstanding goes up.
!o reali%e cash" the employee must exercise theoptions and then sell the underlying shares.
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A t
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Agency osts an -ners pStructure* The Case o.Privati/ation
/rivati%ation 3 government divestiture
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Prior 0iterature on Privati/ation
/rivati%ation benets reali%ed'egginson et al. #,>>?" @F$
Firm-level improvements in protability and
e=ciency following privati%ation
" BF&$*ven after divesting portions of a rm" a
ma)ority of former &2*s are still ultimatelyunder government control
2 - 11
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Prior 0iterature on Compensation
4ompensation based on rmperformance and e0uity-basedincentives aligns goals
@ensen and 'eckling #,>CD" @F*$2wnership linked to compensationEart%ell and &tarks #A" @F$
8nstitutional owners related to higherperformance-based compensation and loweroverall levels of compensation
2 - 12
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Compensation in Privati/ed irms
!he :G earlier wave of privati%ation #,>HA-,>>?$ 4ragg and ;yck #A" @L*2$
No relation between compensation and performance in&2*s
&trong relation in privati%ed rms( even stronger thanin de novo private rms 5uthors recogni%e this result may not be generali%able to
other institutional settings" depending on analystcoverage and legal system
4hina more recent privati%ation wave#,>>I-now$ 4ao et al. #A,," @4F$
4*2 pay is insensitive to performance when thegovernment is the controlling shareholder 2 - 13
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Motivation
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1ypotheses
6ased on the government as a uni0ueshareholderE,a 4*2s of privati%ed rms have a higher
total pay
;eep-pockets of government ownersE,b 4*2s of privati%ed rms have a lower
total payalue of per0uisite consumption and political benets
EA 4*2s of privati%ed rms have a lowere0uity-linked component of compensation as afraction of total pay Less concern with external nancing
&oft-budget constraints 2 - 15
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Main Compensation %ariables
!otal pay&alary
6onuses
&tock
2ptions
Long-term incentive plan #L!8/$
*mployer contribution to pension
5d hoc payments #e.g." relocationbenets$
*0uity proportion of total pay#&tock M 2ptions M L!8/$ !otal pay 2 - 16
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2nivariate esults
Privatizedfirms
De novoprivatefirms
Mean diff.
(Privatized De
novo)
p-value Count(firm-years)
Total Pay
Full sample $3.93 mil $3.4 mil $!."# mil !.! %"9
Matched sample $3.9& mil $".#! mil $#.#4 mil !.! &4&
'uity proportion of total pay
Full sample #.# *.* &.& !.!! %"9
Matched sample #. .& #.4 !."# &4&
! Privatized firms +ave +i,+er total pay% until e mat+ on firm+arateristis (e.,.% size)
! Privatized firms +ave a loer proportion of euity pay for t+e full
sample.
2 - 17
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egression Analysis
;ependent variable *0uity proportion of total pay (#) () (3) (4)
Privatized firm -!.!&&/// -!.!&&//
(-.*3) (-.3#)
Govt ownership(t-1)
-!.!!3"/// -!.!!3!///
(-3.*) (-.&*)Sample 0ull 0ull Mat+ed Mat+ed
Observations %3!# %3!# &!& &!&
R-squared !.9 !.9 !.3*! !.3*#
! Privatized firms +ave a lowereuity omponent of total pay! 1ovt oners+ip levels lin2ed to a lowereuity omponent to total pay
! ar,er firms and firms it+ +i,+er previous year returns lin2ed to a +i,+er proportion of
euity
! loer proportion of euity ompensation is assoiated it+ a C'5 t+at is also t+e +airman
of t+e 6oard.
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Conclusions
4ontribution shed light on the e+ect of governmentparticipation on managerialshareholder incentivealignment
4*2s in privati%ed rms have lower total pay and
lower e0uity-linked wealth compared to those innon-privati%ed rms
Larger govt ownership #$ is associated with lessincentive alignment via e0uity compensation
Future testing8nstitutional ownership
2ther 4*2 features e.g." gender
2verall rm corporate governance 0uality
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