Topic5-MalayMondal

Here in case of debt linked scenario the executive

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Unformatted text preview: in case of ESO the executive’s 5 6 Adapted from Bebchuk, Fried (2010), “Paying for long term performance”, Harvard press http://www.voxeu.org/index.php?q=node/5292 on 18th Nov 2010 7 | P a g e downside risk was limited, but there was chance of unlimited profit. Here in case of debt linked scenario the executive has to consider both the upside gain and downside risk at the same time. So he’ll be more concerned and responsible before going to execute high risk projects. Shareholder’s Incentive: Debt linked compensation is not only safeguarding lender’s incentive but also safeguarding the stake of the shareholders along 7 . The following diagram explains it. Figure 1: Safeguarding both Lender and Shareholder Incentive by Debt Linked Compensation When the executive compensation is linked with the debt component then the lenders feel that their money will be used optimally by the managers and there is lesser chance of loss. This in turn induces them to lower the lending rate. As the lending rate is lowered it strengthens the bottom line of the firm and hence benefits the shareholders also. If the executives are compensated partly with debt and partly with equity then it will have even better impact. This is obvious from the cyclical relation of the above components. Figure 2: Cyclical Relation of Manager, Lender and Shareholder Incentive 7 http://www.voxeu.org/index.php?q=node/5292 18th Nov 2010 8 | P a g e 4.3 Concerns with Debt Options Intuitively equity is more attractive than debt. So managers may feel it less incentive for themselves if their compensations are tied up with the debt. Again linking debt to compensation is not suitable for all kind of firms, mainly growth firm and new firms. Bond price not true indicator of performance: One means of linking compensation to debt is by allotting company bonds. Now from the bond pricing theory we know that the price (P) of a plain vanilla bond is given by – Here one important parameter worth noting is the “i”, the market interest rate. Thus the bond price depends on the factor which is no...
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