Chapter 10_Notes

Chapter 10_Notes - Chapter 10 Notes 10.1 Overview An...

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Chapter 10 Notes 10.1 Overview An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and manager by basing the manager’s compensation on one or more measures of the manager’s performance in operating the firm. Many compensation plans are based on two performance measurers: net income, share price. In this chapter we will see that, in contrast with the simple incentive plan discussed in Chapter 9, real incentive plans are more complex and detailed and span multiple periods. 10.2 Are incentive contracts necessary? Fama (1980) argues that incentive contracts are not necessary because the managerial labour market controls moral hazard. If a manager can establish a reputation for creating high payoffs for owners, that manager’s market value will increase. If a manager shirks, thus reporting lower payoff on average, that manager’s market value will decline. However, the present value of reduced future compensation will be equal to or greater than the immediate benefits of shirking. Thus, since the manager who is tempted to shirk looks ahead, he/she will shirk. This argument assumes an efficient managerial market that properly values the manager’s reputation. In addition, reputation formation needs the multi-period horizon. Thus, the reservation utility is not taken as a constant similar to a one-period model. Therefore, Fama argues, if the manager considers the downward effect of current shirking on the reservation utility of future employment contracts, shirking will be deterred. Fama’s argument does not consider that the manager may try to “fool” the market by opportunistically managing earnings to cover up shirking. Since persons with a tendency to do this will be attracted to the opportunity, the managerial labour market is subject to adverse selection and moral hazard. However, such behaviour will eventually be discovered, in which of case the manager’s reputation will be destroyed. E.g., GAAP limits to some extent the manager’s ability to cover up shirking or accruals reverse. Wolfson’s (1985) empirical research questions Fama’s theory. He shows that an agent’s past success in generating payoffs for investors does not perfectly predict that he/she always
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Chapter 10 Notes “works hard”. Thus, the managerial labour market is not completely effective in controlling moral hazard. The empirical research of Bushman et al. (2006) shows a low correlation (34%) between a firm’s earnings response coefficient and the change in its managers' cash compensation. This suggests that net income is partially informative about manager effort – higher cash compensation is related to increased investor probability of high future firm performance. However, net income is not fully informative about effort – if it were, the correlation would
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Chapter 10_Notes - Chapter 10 Notes 10.1 Overview An...

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