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reward a mediocre yr following a poor prev yr; does not reward a good year following a better year o % industry (hard to determine) 2. Carryovers - Bonus carryover Advantages: 1. More flexible; payment not determined automatically by formula; BOD can exercise their judgment 2. Can reduce magnitude of the swings that occur when bonus is strictly based on formula (lower volatility) - Disadvantages: relate less directly to current performance 3. Deferred Compensation - Payments of bonus may be spread out over period of years - Advantages: o Cash income in coming year can be estimated w/ reasonable accuracy o Smooth cash receipt o Retired manager continue receiving $ after retirement; tax advantage o Deferred time frame encourage long-term oriented decision - Disadvantages: o Deferred amt not available in the year earned o Bonus not related to performance of current year (less incentive) o Deferred bonus may not vest (N/A if leaves company) golden handcuff: disincentive for mger to leave company Long-term Incentive Plans (5) 1. Stock Options - Right to buy shares @ future date @ specified price - Gives manager equity they can retain (even if they leave company) - Restricted stock mgmt. not permitted to sell for a specified period - Advantages o encourage focus on long-term performance o upside potential attract highly talented employees o motivate innovative ideas o lower salary & bonuses o SO value does not reduce bottom line - Disadvantage: risk of decrease in price, interest costs w/ holding stock 2. Phantom Shares (deferred cash bonus) Awards shares for bookkeeping purposes only @ end of period: award = appreciation in MV of stock since date of award in cash or share; no transaction cost; no risk & interest cost from stock option
3. Stock Appreciation Rights (deferred cash bonus) - Right to receive cash payments based on increase in stock value from time of award until a specified future date
4. 5. -
Same advantage as stock option Performance Shares Awards a specified # of shares to manager when specific long-term goals met E.g. % growth in EPS in 3-5 years; not influenced by price of stock Advantage: Award based on performance that the exec can control Disadvantage: limitation of basing bonus on EPS; higher EPS might not mean higher economic worth Performance Units Cash bonus paid when long-term goals are met Combines aspects of stock appreciation & performance shares Useful in non-public traded companies
Benchmarks for comparison 1. BU mger participates in dev of profit budget 2. Budge is challenging but attainable 5. Bonus Determination Approach 1. Formula based - Advantage: Precise; not biased - Disadvantage: less attention to performance of unquantifiable activities (R&D; HRM); sub to est. - When mgmt. control lvl is low, # indicator is less valid for mgers performance measurement: o When BU mger inherits problem created by predecessor o BU highly interdependent with other BU; decision influenced by outside individuals o Strategy requires greater attention to LT concerns 2. Subjective 3. Combination of both 6. Form of Bonus Payment (Cash; Stock; SO; Phatm shr; perf shr)
v.
Agency Theory
Explores how contracts and incentive can be written to motivate individuals to achieve goal congruence Agency relationship exist when principal hires agent (e.g. SH hires CEO) Goal: reduce divergent preferences; (work hard vs. shirk; 401 =_=) Agents: risk & effort adverse Owner: risk neutral Non-observability of agents action: info asymmetry; private information; moral hazard
Control Mechanism 1. Monitoring a. Audited FS b. Effective if agents task is well defined; accurate information 2. Incentive a. Incentive Contracting (link compensation & performance) - Residual loss: resulting divergence of preference - Agency cost: incentive cost, monitoring cost & residual loss - E.g. CEO stock option plan
o o Higher risk = higher incentive compensation = higher cost Lack of direct causal relationship btwn effort & shr price
b. BU manager & accounting based incentives - This is more remote than CEO effort & stock price - Can be based on BU net income - Lower agency cost