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4 Feb 2019

Stock-based compensation and agency problem

In the United States, the stock-based compensation, including the stock option which is the right to purchase the pre-specified number of the own company's shares at a pre-specified price, has been increasing dramatically in terms of the share of the total compensation package of the CEOs and other senior management since the mid-1990s.

(1) If you were a CEO, how do you convince your shareholders to approve such a compensation system? If you were a shareholder of the company, what would be your major concerns?

(2) What would be the potential implication of Variable costs are estimated to be $200 per unit, such a compensation system to the pay-out policy?

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Keith Leannon
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5 Feb 2019

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Specific Electrics Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVP's on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding personal costs. The CEO and EVP's face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior management team can distinguish the three "states" of luck as the quarter unfolds, the Compensation Committee of the Board of Directors (and the shareholders) cannot do so. Once the board designs an incentive contract, soon thereafter the good, medium or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results.

Good Luck Medium Luck Bad Luck

High Effort $1,000,000,000 $800,000,000 $500,000,000

Reduced Effort $800,000,000 $500,000,000 $300,000,000

Assume the company has 10 million shares outstanding offered at $65 initial share price, implying a $650,000,000 initial shareholder value. Since the EVP's and CEO effort and the company's luck are unobservable to the owners and company directors, it is not possible when the company's share price falls to $50 and the company's value to $500,000,000 to distinguish whether the company experienced reduced effort and medium luck or good luck and reduced effort or high effort and bad luck. Similarly, it is not possible to distinguish reduced effort and good luck from high effort and medium luck.

Answer the following questions from the perspective of a member of the Compensation Committee of the Board of directors who is aligned with shareholders' interests and is deciding on a performance-based pay plan (an "incentive contract) for the CEO and EVP's.

1. What is the maximum amount it would be worth to shareholders to elicit high effort all of the time rather than reduced effort all of the time?

2. If you decide to pay 1 percent of this amount (Question 1) as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high effort by paying a bonus should the company's value rise to $800,000,000. What two criticisms can you see of this incentive contract plan?

3. Suppose you decide to elicit high effort by paying a bonus only for an increase in the company's value to $1,000,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?

4. Suppose you decide to elicit high effort by paying the bonus when the company's value falls to $500,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?

5. If the bonus compensation scheme must be announced in advance, and if you must pick one on the three in questions 2, 3, and 4, which one would you pick and why? In other words , under incomplete information, what is the optimal decision by the Board's Compensation Committee (CC) dedicated to act in the shareholders' best interest?

6. Audits are basically sampling procedures to verify with a predetermined accuracy the sources and uses of the company receipts and expenditures; the larger the sampling, the higher the accuracy. In an effort to identify the share price that should trigger a bonus, how much would you, the CC, be willing to pay an auditing consultant who could sample the expense and revenue flows in real time and deliver perfect forecasting information about the luck the firm's sales force is experiencing? Compare shareholder value with this perfect forecast information relative to the best choice among the bonus plans you selected in question 5. Define the difference as the Potential Value Perfect Forecast Information.

7. Design stock option-based incentive plan to elicit high effort. Show that one million stock options at $70 exercise price improve shareholder value relative to the best of the cash bonus plans chosen in Question 5.

8. Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one half-million shares granted at $70 improves shareholder value relative to all prior alternatives.

9. Sketch the game tree designing this optimal managerial incentive contract among the alternatives in question 2, 3, and 4. Who makes the first choice? Who makes the second choice? What role does randomness play? Which bonus pay contract represents a best reply response in each endgame? Which bonus pay contract should the CC of the Board select to maximize expected value? How does that compare with your selection based on the contingent claims analysis in questions 1-8?

WASHINGTON, D.C.—February 17, 2005 Congressman David Dreier (R–CA), Chairman of the House Rules Committee, and Congresswoman Anna Eshoo (D–CA) reintroduced legislation today that will preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares. “Last year, the U.S. House of Representatives overwhelmingly voted for legislation that would have ensured the continued ability of innovative companies to offer stock options to rank-and-file employees,” Dreier stated. “Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) continue to ignore our calls to address legitimate concerns about the impact of FASB’s new standard on workers’ ability to have an ownership stake in the New Economy, and its failure to address the real need of shareholders: accurate and meaningful information about a company’s use of stock options.” “In December 2004, FASB issued a stock option expensing standard that will render a huge blow to the 21st century economy,” Dreier said. “Their action and the SEC’s apparent lack of concern for protecting shareholders, requires us to once again take a firm stand on the side of investors and economic growth. Giving investors the ability to understand how stock options impact the value of their shares is critical. And equally important is preserving the ability of companies to use this innovative tool to attract talented employees.” “Here We Go Again!” by Jack Ciesielski (2/21/2005, http://www.accountingobserver.com/blog/2005/02/here-we-go-again) On February 17, Congressman David Dreier (R–CA), and Congresswoman Anna Eshoo (D–CA), officially entered Silicon Valley’s bid to gum up the launch of honest reporting of stock option compensation: They co-sponsored a bill to “preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.” You know what “critical information” they mean: stuff like the stock compensation for the top five officers in a company, with a rigged value set as close to zero as possible. Investors crave this kind of information. Other ways the good Congresspersons want to “help” investors: The bill “also requires the SEC to study the effectiveness of those disclosures over three years, during which time, no new accounting standard related to the treatment of stock options could be recognized. Finally, the bill requires the Secretary of Commerce to conduct a study and report to Congress on the impact of broad-based employee stock option plans on expanding employee corporate ownership, skilled worker recruitment and retention, research and innovation, economic growth, and international competitiveness.” It’s the old “four corners” basketball strategy: stall, stall, stall. In the meantime, hope for regime change at your opponent, the FASB.

Instructions

(a) What are the major recommendations of the stock-based compensation pronouncement?

(b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)

(c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.

Because of a new product line, your company's sales over the last few months have increased significantly. As a result, the amount of cash held by the company has increased to levels never experienced before. An evaluation by the company's financial staff concludes that the company is holding too much cash. This situation is reported to the stockholders. How do you think the stockholders would react to this information? What options do you have to deal with the concerns of the stockholders without creating any additional risk?

Just–in–time (JIT) inventory systems were first developed by the Japanese and quickly adopted around the globe by many large firms. One of the first to adopt the system in the United States was the automobile industry.

In your opinion, is the JIT system a system that can and should be adopted by small, individually owned firms? Why or why not?

Would the smaller firms have any advantage in terms of their ability to use such a system? Why or why not?

What would be the benefits of employing such a system in the economy?

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