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 FIN413 – Overhead 3

 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 FIN413 – Overhead 3

Conflicts of Interest between Owners and Managers Effort Problem Horizon Problem Differential Risk Exposure Problem Over Retention Problem (Payout Policy) Under Leverage Problem FIN413 – Overhead 3

 Choice of Organizational Structure Potential "Solutions" to the Owner/Manager Conflicts

FIN413 – Overhead 3  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 FIN413 – Overhead 3

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

FIN413 – Overhead 3 "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) FIN413 – Overhead 3

Pension Plans Defined Benefits vs defined contribution plans Vested vs nonvested plans (ERISA) FIN413 – Overhead 3

Tax Deferral Effect of Pensions Salary Pension Raise  Contribution  Taxes  Interest  Interest  5.00 Taxes  Taxes  2.50 Total52.50 Total55.00

 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 FIN413 – Overhead 3

Impact of option plan on: – effort problem – horizon problem – risk exposure problem – payout problem Stock Option Plans Stock Option S* X FIN413 – Overhead 3

 Stock Appreciation Rights (SARs)  Restricted Stock  Phantom Stock  Dividend Units  Base manager's pay on "abnormal" stock return Other Stock-Based Compensation Plans FIN413 – Overhead 3

Bonus (over 90% of medium to large size firms in US have some form of bonus plan) Pool of Available Funds Accounting-Based Performance Plans Contributions to Pool Earnings FIN413 – Overhead 3

Bonus (over 90% of medium to large size firms in US have some form of bonus plan) Pool of Available Funds Accounting-Based Performance Plans Contributions to Pool Earnings

FIN413 – Overhead 3 Bonus (over 90% of medium to large size firms in US have some form of bonus plan) Pool of Available Funds Accounting-Based Performance Plans Contributions to 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 units FIN413 – 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 FIN413 – Overhead 3

 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 Bonus Plans FIN413 – Overhead 3

Investment Opportunity Set Leverage HighLow Compensation Level of Pay LowHigh Conditional on Performance LowHigh Assets in Place Growth Opportunities FIN413 – Overhead 3

Click here to type page Firm Characteristics Level of Compen- sation Use of Stock Options Use of Bonus Plans Growth Options (Merck)Higher Lower Credence Goods (Eastern)Higher Product Warranties (Yugo)Higher Future Product Support (Yugo/Wang) Higher Supplier Financing (Campeau)--- Closely Held FirmHigher SizeHigher RegulationLower Tax Credits--- Marginal Corporate Tax Rate---Lower Marginal Personal Tax Rate---Higher FIN413 – Overhead 3

Investment Opportunity Set Assets in Place Growth Opportunities Cost of Debt Low High (Underinvestment) Benefits of Debt High Low (Free Cash Flow) Predicted Leverage High Low FIN413 – Overhead 3