EXECUTIVE COMPENSATION

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Class Announcements

Assignment #8 due March 17th (today); available on-lineAssignment #9 due March 24th; available on-lineResearch Paper Part #4 due April 3rdBusiness Banquet - April 2nd 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

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Class Objectives

Executive Compensation as an agency contractElements of executive compensation contractsExecutive compensation inflation and adjustments

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Agency Theory: DefinitionAgency theory is branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agents interest would otherwise conflict with those of the principal.

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Agency TheoryIn agency theory, people are assumed to be rational profit maximizing individuals who will promote self interest.Agents:Self-InterestedHave alternative opportunities of use of their timeChoose actions that maximize own expected utility (adverse selection)Effort-adverse (moral hazard)Tendency to shirk (moral hazard)Risk Adverse

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Agency Theory: Executive CompensationAn executive compensation plan is an agency contract between the firm and its managerattempts to align the interests of owners and managerdetails the managers compensation (bonus, shares, options, salary, benefits, memberships, etc.) bases on one or more measures (net income and share price) of the managers effort in operating the firm.

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Contracts Necessary: No1) Managerial labor market - the present value of reduced future compensation will cause managers to avoid shirking.2) Internal monitoring shirking will be detected and reported by subordinate managers3) GAAP limits shirking accruals reverse

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Contracts Necessary: Yes1) Managing release of information manager can disguise the effects of shirking by controlling releases of private information2) Internal monitoring internal monitoring is effective if contract is based on joint contract; if the payoff is a joint effort, shirking by either manager will reduce the payoff for both3) Reputation research suggests that internal and market forces (e.g. labour market) help to control not eliminate tendencies to shirk

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Executive Compensation: StatisticsIn Europe business leaders are paid 3 to 40 times the average employees salary and performance is comparable to North American CompaniesThe average compensation among Canada's top 100 CEOs was $7.96 million in 2012. This compared with the average annual Canadian worker's salary of $46,634.Highest paid CEO in Canada W. Galen Weston, George Weston Ltd., $5.7-billion; #2. Gerald Schwartz, Onex Corp., $981-millionhttp://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/ten-canadian-ceos-with-the-most-valuable-share-holdings/article12147066/?from=12144305

http://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/ten-canadian-ceos-with-the-most-valuable-share-holdings/article12147066/?from=12144305*

Executive Compensation: CanadaHow much Canada's top 100 CEOs got paid last yearThe Globe and Mail (on-line)Published Monday, May. 27 2013, 5:00 AM EDTLast updated Tuesday, Jul. 23 2013, 3:44 PM EDThttp://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/executive-compensation/article12136604/?from=12145005

Executive Compensation: ElementsSeveral compensation componentsTime HorizonMix of short term and long term incentive components balance reward based on current years performance and a longer manager decision horizonShare OwnershipRisk ProfileRisk upper (i.e.. cap) and lower (i.e.. bogey) limits limit variation in executive compensation caused by uncontrollable events in economy or industryIncentiveThreshold levels of performance measures accounting and market based measuresIncentive effects - apparent and measurableNet income and share price are compliments

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Executive Compensation: MeasuresCompany PerformanceTotal Shareholder ReturnReturn On AssetsReturn On CapitalReturn On EquityEPS GrowthEBITDA GrowthNet Income GrowthSee http://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/bang-for-their-buck-compare-executive-pay-days-with-company-performance/article4232218/?from=4246044

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Executive Compensation: Net IncomeNet income must compete with other measures (e.g. share price) in compensation plansThe efficiency of compensation contact may be increased if it is based on two or more performance measuresRelative proportions of each measure:a) precision reciprocal of the variance of the performance (insensitivity to noise trading, market inefficiency, secondly-wide factors)b) sensitivity rate at which the expected value of the measure responds to manager effort (limiting earnings manipulation, one year time horizon)

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Executive Compensation: RiskRisk and return trade off - the more risk the more return compensation requiredRisk avoidance incentives to exert effort will suffer if not enough risk is imposedControlling compensation risk:Limiting downside risk too much risk may be dysfunctional and cause only safe strategies (bogey)Limiting upside risk cap excessive opportunistic risk opportunities which incur a high penalty (cap)Relative Performance Evaluation (RPE) reduces managers risk while maintaining incentives by setting incentive rewards compared with relative average performance of other firms in industryCompensation committee

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Executive Compensation: PoliticsCompensation is unrelated to market value:1) Pay and performance relationship is low for large firms because of size effect2) Small declines in firm value would lead to excessive risk avoidance if compensation is highly tied to performance3) Restriction devalue stock options and stock holdings4) Disclosure of executive compensation allows market to assess compensation 5) Corporate governance policies require independence of compensation committee6) Power theory managers influence own compensation7) Shareholder activism - say on pay votes were introduced for shareholders tow years ago

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Executive Compensation: InflationCompensation inflated by:1) overblown market valuations2) accounting shell games3) phantom profits4) high tech bubble5) lack of transparency

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Executive Compensation: Adjustments1) Alternative options: spin off companies, restricted stock2) Improved disclosure (transparency)3) Indexed options4) Stronger compensation committees5) Regulation (e.g. Sarbanes-Oxley Act in US)6) Shareholder activism say on pay (2010)7) Reversion to bonuses8) Performance measures"Compensation packages paid to chief executive officers have come under intense scrutiny and pressure from shareholders, the media, and the general public. There is no clear relationship between CEO compensation and any measure of corporate performance," Hugh Mackenzie, Canadian Centre for Policy Alternative

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Class Objectives - Revisited

Executive Compensation as an agency contractElements of executive compensation contractsExecutive compensation inflation and adjustments

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*http://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/ten-canadian-ceos-with-the-most-valuable-share-holdings/article12147066/?from=12144305*

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