FIN 413Corporate 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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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?

Executive Compensation

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Conflicts of Interest betweenOwners and Managers

Effort Problem

Horizon Problem

Differential Risk Exposure Problem

Over Retention Problem (Payout Policy)

Under Leverage Problem

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Choice of Organizational Structure

Potential "Solutions" to the Owner/Manager Conflicts

Choice of Organizational Structure

Potential "Solutions" to the Owner/Manager Conflicts

Board of Directors

CEO

CFO/COO

Middle Management

Production Workers

Internal and External Labor Markets

The Market for Corporate Control

Incentive based compensation contracts

– explicit contracts– implicit contracts

Potential "Solutions" to the Owner/Manager Conflicts

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“Suffice it to say that one is the result of an extremely hostile takeover.”

"Fixed" Compensation

Salary

Pension

Insurance

Perks

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 Contribution

100.00

Taxes 50.00 Interest 10.00

Interest 5.00 Taxes 55.00

Taxes 2.50

Total 52.50 Total 55.00

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.

Stock Option Plans

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Impact of option plan on:

– effort problem

– horizon problem

– risk exposure problem

– payout problem

Stock Option Plans

StockOption

S*X

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Stock Appreciation Rights (SARs)

Restricted Stock

Phantom Stock

Dividend Units

Base manager's pay on "abnormal" stock return

Other Stock-Based Compensation Plans

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Bonus(over 90% of medium to large size firms in US have some form of bonus plan)

Pool of Available Funds

Accounting-BasedPerformance Plans

Contributionsto Pool

EarningsFIN413 – Overhead 3

Bonus(over 90% of medium to large size firms in US have some form of bonus plan)

Pool of Available Funds

Accounting-BasedPerformance Plans

Contributionsto Pool

Earnings

Bonus(over 90% of medium to large size firms in US have some form of bonus plan)

Pool of Available Funds

Accounting-BasedPerformance Plans

Contributionsto Pool

Earnings

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 unitsFIN413 – Overhead 3

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.

Bonus Plans

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Choice of Organizational Structure

Potential "Solutions" to the Owner/Manager Conflicts

Board of Directors

CEO

CFO/COO

Middle Management

Production Workers

Internal and External Labor Markets

What determines where a divisional manager's bonus payment falls along this spectrum?

Divisional Firm

Performance Performance

Bonus Plans

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Investment Opportunity Set

Leverage High Low

CompensationLevel of Pay Low High

Conditional onPerformance Low High

Assets inPlace

GrowthOpportuniti

es

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Click here to type pageFirm Characteristics

Level of Compen-

sation

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

Supplier Financing (Campeau)

--- --- ---

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 HigherFIN413 – Overhead 3

Investment Opportunity Set

Assets inPlace

GrowthOpportuniti

es

Cost of Debt Low High

(Underinvestment)

Benefits of Debt High Low

(Free Cash Flow)

Predicted Leverage High Low

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