Executive Compensation: An agency problem:
The globalized world of today has seen many scandals derived from the compensation schemes that are granted to top-level executives from their respective organizations. The compensation policies put in place in organizations are a result of a fundamental agency problem, the problem being that of the principal and the agent relationship. The issue arises due to the principal who hires the agent to perform day-to-day management tasks and oversee operations; the principal cannot directly monitor the performance of the agent and how well the agent’s efforts translate into that of the company’s performance. However, the principal still has to compensate the agent on a yearly basis regardless of management effort. The separation of ownership and control is the root cause of the agency problem. The owners of a firm cannot directly monitor management efforts, and the agent’s performance is not directly related to that of the company’s performance in a semi-strong market form. The question then becomes how are top tier managers compensated when in reality their performance cannot be measured in a timely and an accurate manner. Thus the executive compensation as stated in the text is an “agency contract between the firm and its manager that attempts to align the interest of the owners and the managers by basing the managers compensation on one or more measures of the manager’s performance.” This alignment of interest is key in ensuring that the manager acts in a manner that best benefits its shareholders. However, streamlining company profitability into that of manager compensation leads to opportunistic behaviour by the manager. On the other side of the coin, not paying managers enough and not streamlining managers’ compensation with profitability will lead to information asymmetry in the form of moral hazard. Moral hazard, in the aforementioned context means that managers will shirk from performing their duties, as they are not motivated, that is because regardless of what they do, there is no incentive to do better as the compensation for outperforming or underperforming is the same. With that stated, the discussion leads to controlling managers risk taking behaviour while still allowing them to enter into contracts. Because this flexibility is what helps managers outperform. Thus managers’ performance can be monitored through the use of various performance measures discussed hereafter. Performance Measures:
The two major performance measures discussed in the presentation that the principal can use to measure manager performance are: * Net Income
* Share Price
Net Income: is the more current year-to-year performance measure whereby managers can be evaluated on a yearly basis. What managers do in a year is reflected at the end of the year in the financial statements. Thus a net income acts as a current year performance measure that measures managers’ short-term decisions. Usually a mangers short term compensation are tied in with the net income and these are usually known as a bonus plan, where the manager receives a certain percentage of the earnings and is usually referred to a short term incentive plan and its main objective is to compensate managers for their short term decision making. Stock Price: is a different measure than that of net income, in the sense that it measures long term decision making abilities of a manager. Stock price is volatile on a day-to-day basis, however on a macro level over years it demonstrates a steady trend, which can give a great insight into the manager’s performance over the long run. The company can ensure manager’s motives are inline with that of the company objectives by streamlining manager’s compensation with that of the long run stock price of the company; this is done through the use of employee stock options (ESO’s). ESO’s are granted to the manager at a date, and they are allowed to exercise their options to sell stock at a...
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