week4B - Performance and Compensation Thomas Noe Tulane...

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Performance and Compensation Thomas Noe, Tulane University
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Overview Managerial rewards and performance The Firm mgr. owners rival management teams competitors creditors int. labor market/ contracts/competition
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Lecture objective Students should understand how External labor markets Internal labor markets Compensation contracts can be combined to create compensation packages that align shareholder and managerial interests
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External Labor Market Replacement by Board absent external pressure Fairly rare, according to Jensen and Murphy, (1990) not usually a significant factor unless firm is grossly underperforming relative to industry norms. The market for corporate control . Significant constraint on managerial opportunism.
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External labor market Replacement/reputation loss related to financial distress Common, 64% of incumbent CEOs at the time of workout and/or bankruptcy lose jobs within 4 years. (Gilson, 1990)
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External Labor Market: Summary Constrains managerial opportunism However, high transactions costs leave room for other controls to effect improvement
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I nternal Labor Market: The agency relationship Agency Relationships Definition: one individual, the agent, is hired by another individual, the principal, to increase the value of an asset the principal owns. Examples of Agency Relationships doctor/patient expert/client manager/shareholder
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Agency The agency contract what the agent will receive given actions taken by agent outcomes observed by principal Constraints on agency contract verifiability incentive compatibility voluntary participation
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Agency Verifiability --The values of the variables contracted on must be capable of verification by outside parties Incentive compatibility --It must be in the agents interest to undertake the actions called for in the contract. Voluntary Participation --agent must be willing to accept the contract offered by the principal.
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Agency Issues in Contract Design verifiability vs. observability --some variables are observable by all interested parties but their values cannot be verified by third parties limited liability --optimal design cannot force the agent consumption below some fixed lower limit (say zero).
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Agency risk aversion --If the agent is risk averse, and the relationship between effort and contractible variables is noisy, the agent will require a premium for bearing the risks associated with high-powered incentive contract, making such contracts very expensive, and possible unattractive to the principal.
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Example: Agency Manager hired to manage an asset Manager’s effort is not verifiable but the firm’s value is observable. The effort of the manager affects the cash flow produced by the asset The more effort the manager makes the greater the likelihood of a good outcome But, even with high effort a good outcome is not assured
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Example Agency Prob{ Cash Flow | Mgr’s effort} CF = 1.0M CF = 0.5 M High Effort 0.75 0.25 Low Effort 0.50 0.50 Value of firm with low effort, V( L ) = 0.750M Value of firm with high effort, V( H ) = 0.875M
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