Term
| Is there a need for incentive contracts? FAMA |
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Definition
no
-reputation of creating high payoffs for owners will motivate managers to work hard
-higher market value for managers
-requires a well working managerial labor market |
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Term
| FAMA says internal monitoring is..... |
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Definition
| when lower level managers will detect and report any shirking to get ahead |
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Term
| WOLFSON: is there a need for incentive contracts? |
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Definition
yes
- reputation helps but is insufficient
-managers may still shirk and use reporting to conceal it
- opportunistically manage earnings
- GAAP/IFRS can limit opportunism
- labor markets do not fully work well
- analysis of GP/ LP agreements in oil & gas industry/ non-completion problem |
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Term
EXAMPLE:
Assume net CF are 80% to LP and 20%GP. GP is responsible for all development costs and drills test oil well to indicate oil is present. Estimated value= 3M; additional development costs=1M; NPV of project=2M. What will happen? |
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Definition
GP knows drilling results, LP doesnt (moral hazard)
GP is responsible for costs to complete well/bring into production but GP will only complete the oil well if its share of expected revenue exceeds its completion costs.
Knowing this, LP protects by bidding down the price. Reputation effect increases price. Price was relatively lower for developmental wells where non-completion problem is more severe. |
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Term
| SO OVERALL: do we need incentive contracts? |
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Definition
yes
-inability to eliminate all shirking
-reputation is not enough
-need some incentives |
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Term
| Theory of executive compensation. what are the topics? |
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Definition
derives from agency theory
- desirable properties
-net income vs. share price
-manager decision horizon
-role of risk |
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Term
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Definition
-principle wants to hire agent
-principal and agent are rational
- agent is risk averse, principal is risk neutral
-principal wants agent to work hard but agent is work averse |
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Term
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Definition
moral hazard problem
-- principal wants high effort to maximize firm value but cannot observe manager's effort
-- agent (manager) wants to maximize expected utility, has disutility of effort, may shirk |
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Term
| Desirable properties of performance measure |
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Definition
sensitivity between performance measure and effort
--- the harder the manager works, the faster the rate at which the expected value of a performance measure increases
precision of the performance measure in predicting the payoff from current manager effort |
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Term
| common compensation performance metrics |
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Definition
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Term
| share price vs. net income |
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Definition
share price is high in sensitivity, low in precision
net income is low in sensitivity and high in precision
-- acocunting recognition lag(such as r&d, advertising) results in lower sensitivity
both may be desriable but there is a tradeoff between the two |
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Term
| how to increase sensitivity of net income? |
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Definition
-current value accounting reduces recognition lag
-full disclosure to make it more difficult for managers to disguise shirking. it will also enable better evaluation of earnings persistence. persistent earnings are more sensitive |
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Term
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Definition
share price increases with long -run effort
net income increases with short run effort
- when there is congruency of performance measure(to payoffs) short/long run does not matter, but if not congruent then the decision will have a mix of share price and net income measures. |
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Term
| short run vs long run effort hand out |
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Definition
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Term
| role of risk between managers and owners? |
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Definition
-managers bear risk: lower performance measure precision leads to more risk
- owners need to control compensation risk bc if there is too little risk, it reduces the managers effort incentive. too much risk and managers avoid risky projects and/or enter into excessive hedging |
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Term
| How to control compensation risk? |
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Definition
- relative performance evaluation (compare 2 peers)
- bogey of compensation plan (controls downside risk)
- cap of compensation plan (controls upside risk)
- monitoring by board, compensation committee
- conservative accounting |
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Term
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Definition
| how are measures of precision and sensitivity related to the use of market and accounting measures in executive compensation? |
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Term
| How are measures of precision and sensitivity related to the use of market and accounting measures in executive compensation? |
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Definition
-performance mix- relative influence of change return of equity and returns on change in cash compensation
-precision(noise in ROE measure)
-sensitivity (firm growth rate)
-personal wealth
lambert and larcker |
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Term
| What is Lambert and Larckers performance mix formula? |
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Definition
=f(NOISE, CORR, GROWTH, OTHER)
the greater the performance risk, the greater influence returns have in cash compensation |
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Term
| Lambert and Larckers findings |
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Definition
-cash compensation is more highly correlated with ROE than with return on shares
- correlation is higher when noise in net income is lower
- correlation is lower for growth firms
- higher weight on ROE in compensation plans when correlation between ROE nad return on shares is low |
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Term
Is executive compensation too high?
Jenson & Murphey's thoughts?
Gayle and Miller's thoughts? |
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Definition
J&M- no when considered in relation to changes in firm market value (possible large firm effect); executives do not bear enough risk
G&M- increase in compensation in order to decrease moral hazard |
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