FIN 413
Corporate Financial Policy
Clifford W. Smith, Jr.
Spring 2007
Presentation 3
* Covers readings on course outline through Brickley/Smith/Zimmerman, Chap 14 and 15
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Executive Compensation
 Benchmark Compensation Plan
Suppose I offer a corporate manager a series of
prespecified salary payments -- from the time he is hired
until the time he retires -- with the only contingency that if
the firm goes bankrupt, he will be fired, and his salary
payments will be terminated.
 What are the conflicts of interest that will likely
arise between owners and managers under this
benchmark compensation plan?
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Conflicts of Interest between
Owners and Managers

Effort Problem

Horizon Problem

Differential Risk Exposure Problem

Over Retention Problem (Payout Policy)

Under Leverage Problem
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Potential "Solutions" to the
Owner/Manager Conflicts

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Choice of Organizational Structure
Potential "Solutions" to the
Owner/Manager Conflicts

Choice of Organizational Structure
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers

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Internal and External Labor Markets
Potential "Solutions" to the
Owner/Manager Conflicts
 The Market for Corporate Control
 Incentive based compensation contracts
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–
explicit contracts
–
implicit contracts
“Suffice it to say that one is the result of an
extremely hostile takeover.”
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"Fixed" Compensation
 Salary
 Pension
 Insurance
 Perks
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Salary
 Typically largest component (but not always)
 Within contracting period salary is fixed
(close to our benchmark case)
 Implicit contract to renegotiate salary in good
faith based on performance
 No one in the firm determines his/her own
salary (compensation committee of board
comprised of outside boardmembers)
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Pension Plans

Defined Benefits vs defined
contribution plans

Vested vs nonvested plans (ERISA)
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Tax Deferral Effect of Pensions
Salary
Pension
Raise
+100.00
Taxes
-50.00
Interest
+5.00
Taxes
-2.50
Total
52.50
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Contribution
+100.00
Interest
+10.00
Taxes
-55.00
Total
55.00
Stock Option Plans

Stock options granted to managers
–
Typically have approx. 5 years to expiration
–
European options (cannot be exercised early)
–
Restricted (cannot be sold before expiration)
–
The option is actually a warrant (when
exercised, the number of shares outstanding
increases), but dilution effect is small.
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Stock Option Plans
Impact of option plan on:
–
effort problem
–
horizon problem
–
risk exposure
problem
–
payout problem
Stock
Option
S*
X
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Other Stock-Based
Compensation Plans
 Stock Appreciation Rights (SARs)
 Restricted Stock
 Phantom Stock
 Dividend Units
 Base manager's pay on "abnormal" stock
return
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Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have
some form of bonus plan)
Pool of Available Funds
Contributions
to Pool
Earnings
FIN413 – Overhead 3
Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have
some form of bonus plan)
Pool of Available Funds
Contributions
to Pool
Earnings
FIN413 – Overhead 3
Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have
some form of bonus plan)
Pool of Available Funds
Contributions
to Pool
Earnings
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Bonus Plans

Impact of bonus plan on
– effort problem
– risk exposure problem
– payout problem
– horizon problem

Long-term performance plans -- similar to
bonus plans, but based on 3 to 7 year earnings
performance

Performance units
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Bonus Plans

The use of accounting numbers vs stock prices
for incentive compensation plans
–
–
–

Accounting numbers allow disaggregation of
performance measures
Accounting numbers can provide perverse
incentives
Accounting numbers subject to manipulation
Top managers (who set accounting policy)
typically compensated with stock-based plans.
Lower level managers more likely to receive
bonus.
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Potential "Solutions" to the
Owner/Manager Conflicts

Choice of Organizational Structure
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers

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Internal and External Labor Markets
Bonus Plans
What determines where a divisional manager's
bonus payment falls along this spectrum?
Divisional
Performance
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Firm
Performance
Investment Opportunity Set
Assets in
Place
Growth
Opportunities
Leverage
High
Low
Compensation
Level of Pay
Low
High
Conditional on
Performance
Low
High
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Level of
Compensation
Use of
Stock
Options
Use of
Bonus Plans
Growth Options (Merck)
Higher
Higher
Lower
Credence Goods (Eastern)
Higher
Higher
Higher
Product Warranties (Yugo)
Higher
Higher
Higher
Future Product Support
(Yugo/Wang)
Higher
Higher
Higher
---
---
---
Closely Held Firm
Higher
Higher
Higher
Size
Higher
Higher
Higher
Regulation
Lower
Lower
Lower
Tax Credits
---
---
---
Marginal Corporate Tax Rate
---
Lower
Lower
Marginal Personal Tax Rate
---
Higher
Higher
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Firm Characteristics
Supplier Financing (Campeau)
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Investment Opportunity Set
Cost of Debt
Assets in
Place
Growth
Opportunities
Low
High
High
Low
High
Low
(Underinvestment)
Benefits of Debt
(Free Cash Flow)
Predicted Leverage
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