Firm’s problem and the optimal solution is to

Firm’s financial
performance is largely depending on investment decisions made by top
management. Corporate long run investments in new projects are essential for
the future growth of the organisation but they are likely lead to the
depression of cash flow and earnings in the short term. Managers may undertake
myopic actions that increase stock price temporarily and exploit it by
exercising vested options and selling equity for their own good (Ladika & Sautner, 2013). Therefore, there is a need for
an effective pay contract or compensation pay scheme to capture mangers’
incentives and shape their behaviors, which ensures managers put forth their
best effort according to their best interest. The connection between incentive
systems and investment decisions is related to principal agent problem and the
optimal solution is to align the interest of shareholders and CEOs. To ensure
the long run growth of the firm, ideally, the CEO should take risky decisions
but not engage in excessively risky decisions. The objective of the essay is to
explore the how the compensation pay contract can be design to encourage the CEO
taking risky decision but avoiding imprudent decisions. This essay will
firstly demonstrate principal agent theory and its underlying assumptions;
then, the next session will discuss various compensation pay scheme at a deeper
level; The next session refers to critically examine compensation pay scheme
and find optimal solutions; Finally, conclude the essay.

 

PRINCIPAL-AGENT
PROBLEM& THE GENERAL SOLUTION:

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Principle-Agent
problems arises from the separation of control and ownership between
shareholders and managers that have different interests (Baye and
Prince, 2017). Before propose the general solution, the
essay will introduce the assumptions of principle agent theory as follows:

 

The first assumption is
that there is a separation of ownership and control in agency theory. Large
corporations are owned by many shareholders so that no single shareholders
really have the power to control the behaviors of the managers of the
corporation. In situation like this, the interests of the managers and the
shareholders can be diverged widely (Salehnejad, 2017a). The managers may
pursue the maximization of their benefits such as power, reputation, wealth or
even leisure, and they work in an environmental and institutional context that
many external factors (company law, auditing, public opinion) should be
considered (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 managers
and senior managers may exploit their positions to pursue benefits at the
expense of long-run growth of the firm (Baye and Prince, 2017).

 

The second assumption
underlying the firm’s revenue depending on managers efforts. The higher is
effort, the higher is the profit. The essence of the problem is that the
manager likes to earn incomes but also consume leisure. Clearly, if the manager
spends 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 his
efforts and choose consuming efforts (Salehnejad, 2017a).

 

The third is connected
to asymmetric information, which means managers have more information about
themselves than shareholders have. This leads to the moral hazards situation
where shareholders are not able to observe the hidden actions of managers in an
efficient or feasible way (Baye and Prince, 2017).
In addition, even all actions of the manager are observable, shareholders may
not have the expertise to judge whether the manager’s actions are in line with
their best interest due to high dispersion of shareholders and the lack of
knowledge (Abdalla, 2008). Besides asymmetric information, the uncertainty of
the future income also adds the difficulty to examine managers’ performance (Salehnejad,
2017a). The firm are subject to uncertain conditions such as depression and
profits may be low even if mangers make the most appropriate investment
decisions for the firm. It is hard to determine whether the manager has spent
his best efforts simply by observing firm’s profits.

 

The last assumption is
that shareholders tend to be less risk-averse than managers. By investing in
multiple corporations and unrelated market, shareholders may be able to
diversify their risk (Salehnejad, 2017a).. In
contrast, the manager only operates in one company and his income relies
heavily on the company’s profits. In addition, his skills and knowledge may be
limited to a specific firm or industry, which makes it harder for them to take
the risky decision which may yield high profits (Hovenkamp, 2009). This leads
to another conflict of interest: managers prefer short-run projects with safety
but low returns while shareholders prefer long-run projects with high risk but
huge profits.

 

It was reported in 2001
that the new CEO of 3M corporation, James McNerney, dropped the 30% rules which
measures divisional manager’s performance through computing what fraction of
the products are new to this year. Managers used to be under this rule had
little incentives to innovate products and from 1995 to 2000 the firm’s stock
price lagged it the average of S (Hymowitz, 2002).
This is a typical example of principal-agent problem which the interest of
divisional managers did not align with the frim. It is important for the firm
to find the right incentives for the manager and compensation pay contract may be
a general solution to this problem.

 

Due to the conflict
interest between different managers and shareholders, there is a need to set
compensation varied with company’s overall profits to which is a floated salary(??(e)), so that managers’ interest is
in line with shareholders’. On the other hand, due to the uncertainty of the
state of the economy, the profit of company is unstable and risky. A fixed
salary(K) should be introduced
independently to incentivize managers to be less risk-averse and to purse
promising risky investment projects. In fact, it is suggested that the fixed
salary should be below market competitive levels as (Murphy, 2009). The
resulting formula is as follows:     

                          S(e) = K + ??(e)

However, the conceptual
model only considers few factors and in the real world many variables are at
play (Salehnejad, 2017a).   

 

COMPENSATION PAY
SCHEMES& INVESTMENT BEHAVIOUR:

There are many debates
on the level and structure of CEO compensation. The level of CEO’s pay has been
increasing dramatically over decades. Frydman (2010)
documented that the total salary of CEO in US large companies has surged by
five times in the last 30 years. On one hand, the high level of CEO pay is seen
as the results of executives’ ability to set their own pay and extract rent
from firms they manage, which is due to the weak corporate governance and
acquiescent board. This can result in inefficiently high level of compensation
and managers may take decisions that can only increase their pay but fail to
align the interests with shareholders. (Bebchuk and Fried, 2004). On the
other hand, a growing literature argues that the growth in CEO pay is the
efficient result of rising demand of CEO effort or scarce managerial talent. If
higher talent CEO is more valuable in larger firms, then larger firms should
offer 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 importance
of transferable rather than human- specific capital for the CEO’s job, which
raises pay directly through expanding CEO’s outside options. The rise of the
possibility of switching job may induce CEOs to select short-term to increase
their external marketability, which aggravates the conflict of the interest
between managers and shareholders. In a nutshell, it is not the high level of
CEO pay that has impact on the investment decisions, it is the reasons behind the
phenomenon that could induce CEOs to be behave myopically.     

 

As for the structure of
pay, most compensation schemes include fixed salary, annual bonus, long term
incentive plan(LTIP), RSU and stock options. Since 1980s the proportion of
stock option, share, and LTIP compensation started surged, and by 2005 them made
up to 60% of the total CEO pay (Frydman& Jenter, 2008, p. 7). The relative
importance of these compensation elements has changed considerably overtime, and
today’s bonuses were tied to one or more measures of annual accounting
performance and paid in either cash or stock (Frydman& Jenter, 2008, p. 6).

 

Stock and options are
incentives to motivate managers to take appropriate investment decisions. However,
they differ along two dimensions Since options are risker, $1 of options is
worth 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 price
rises after the options are granted, $1 of options provides greater incentives
than 1$ of stock (Gabaix and Edmans, 2009). Typically, options
give the CEO the right but not the obligation to purchase or sell a given
number of share at a certain level of price at some future data (Berk&
DeMarzo, 2014, p. 707). Options may be an efficient way to incentive the CEO as
the options are close to worthless if the stock price won’t rise. However, when
it comes to vesting period, it can be hard for the CEO to improve the company’s
performance by opening new markets or developing new products in a short
period. To boost the stock price, the CEO may use short-term techniques and
cuts R, advertising, and capital expenditure at the expense of the future
growth of the company, which leads to managerial myopia (Edmans, Fang
and Lewellen, 2013). Study
found that having shorter investing period may increase the chance of short-termism
(managerial myopia), causing managers reducing their horizon to short term
projects and selling their boosted options before long-term cost of his myopic
decision is realized (Ladika & Sautner, 2013).
Researchers found that a 10% deduct in the vesting periods of the CEO’s stock
option grant caused a decrease of 0.023 in capital expenditure (Ladika & Sautner, 2013). In addition, another
survey indicates that an interquartile increase in vesting-induced equity sales
relates to a 0.25% decline in the growth of R&D and an average decline of
$2.2 million per year (Edmans, Fang
and Lewellen, 2013). On the other hand, the CEO
may be concerned with the firm’s shorter stock price for various reasons. He
may be under the pressure of CEO’s performance assessment that is through
judging short-term stock price, which can also lead to short-termism (Edman et al,
2014).

 

In conclusion, the
major problem of the current payment scheme is that it induces CEOs to be
short-termism, reducing in R&D, advertising, capital expenditure at the
expense of long-run growth. In addition, managers experience no reduction in
real wealth if the stock price decreases, which allows   managers
to 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 compensation
contract and governance mechanisms that motivate CEOs to focus on long term
further growth and avoid excessively risky decisions.

SOLUTIONS:

From the point of
Edmans (2009) view, there are main two problems in existing schemes. First,
stock and option have shorts vesting periods, allowing CEO to cash out early
and liquidate their holdings before the long-run cost is realized. One
principle (long-horizon principle) for the optimal solution is that the
long-term incentives must be provided for executives to maximise long-term
value. Second, existing schemes fail to keep up with firm’s changing
conditions. Stock and options will have little incentive effect to the manager
if the firm’s stock price plummets. Another principle (constant percentage
change principle) is that the percentage change of pay is varied with the
percentage change of the firm’s value, and the appropriate proportion should be
based on their industry and life cycle (Gabaix and Edmans, 2009).
Researchers suggest that incentive accounts can be a possible solution to these
problems – rebalancing and gradual vesting to satisfy the long-horizon
principle. If the share price falls, managers will be required to hold more
equities than with a reduction in cash of his pay to maintain incentives, which
also rewards CEO for failure. Each month, a fixed fraction of the incentive
account vests and full vesting will occur only after several years from leaving
the firm. Since the manager has great wealth connected the firm’s value after
his departure, he has little incentives to focus on short-term investment
projects or manipulating earnings. The drawback of gradual vesting is that it
raises cost. Managers may require a higher salary as a compensation due to the
risk imposed on them. As for implication, gradual vesting can be enhanced by
adding benchmarking to market performance to ensure rewards are not for luck.

 

Inside debt is another
proposal especially for highly leveraged firms such as investment banks. This
proposal emphases on solving the imprudent risk-taking and tires to link
compensation to firm risk. It refers to delay the CEO’s receipt of a certain
amount of current-year salary and bonus, leaving it vested in the firm at a
fixed rate of return and until retirement or even after retirement(Salehnejad,
2016a). It has been argued that inside debt aligns the interests of the CEO
with both shareholders and creditors and prevent the CEO take excessively risky
decisions. Some empirical evidences have supported the use of inside debt. A
study by Tung and Wang (2010) reported that bank CEO’s with higher level of
inside debt compensation reduced firm’s risk and thus performed better during
the subprime financial crisis. Edmans (2009) also adds that debt compensation
can be an optimal element in CEO pay, particularly when a company faces
financial difficulties. However, Bebchuk and Jackson have argued that debt
represents inefficient rent extraction, as the executives take advantages of
limited disclosure rules to pay themselves high pensions. As disclosure of debt
compensation has been extremely limited, debt compensation is not the position
of commonplace.    

 

Severance pay involves rewarding
CEOs for failure and has been particularly controversial in compensation in the
recent financial crisis (Yermack, 2006). Manso (2008) shows that if an
important aspect of the CEO’s job is to develop new technologies rather than
exploit existing ones, rewarding for the failure can be the optimal feature in
the compensation schemes. On the other hand, it been argued that severance pay
is difficult to rationalize with a standard principal-agent model, as the CEOs
only control efforts (Edmans and Gabaix, 2009).
Furthermore, the CEO may fail to spend effort with long- lasting consequences
as he fears dismissal if the board is strong (Almazan& Suarez, 2003).    

CONCLUSION:

As there are several
problems of current compensation schemes, different solutions came up with
emphasis on different issues. Firms’ value is subject to changing conditions
and stock price may decline. To smooth the effect on incentives for the
managers and to induce mangers long-term focused behaviours, optimal contract
can involve the Incentive account. However, this solution can be costly to the
firm and in application it should be accompanied by other features to ensure
the fair performance assessment of the CEO. To avoid mangers taking excessively
risky decisions when the firm faces difficulties and to align interest of the
COEs with shareholders and creditors, inside debt can be an efficient tool to
reduce firm risk and ensure managers perform better. On the other hand, debt
represents inefficient rent extraction and disclosure of debt compensation has
been extremely limited, which is not commonly accepted by executives. Severance
pay is efficient when the firm is exploring new technology as the manager is
rewarded for the failure. However, it has been reported that severance pay can
deter the CEO from entrenching himself by hiding negative information that may
lead to his dismissal. In a nutshell, there is no single optimal compensation schemes
for all cases and different solutions should be assigned with different
situations.