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to work better. Manager effort is motivated because the executive knows that the
disclosures reveal information about the compensation committee’s evaluation of
the managers’ performance and the types and amounts of compensation awarded.
The manager also knows that investors will relate this compensation to firm
performance. If, due to low effort, performance is poor relative to compensation, the
manager’s reputation will be damaged and reservation utility for future
compensation contracts will be reduced.
b. The answer depends on how well the managerial labour market works. If it works
well, RBC’s relating of its total compensation to the median of its Peer Group will have
no effect on compensation levels in the banking industry. Managers will continue to
receive compensation consistent with the value of their services given by all publicly
available information, including information in the pay disclosure rules.
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13. a. Reasons for a market–based approach to stock option expense:
• Zions may feel that estimates based on models such as
Black/Scholes are unreliable, and may overstate ESO expense.
Sources of unreliability include possible bias due to the need to
estimate the timing of ESO exercise by its employees, and also due
b. Model–based estimates of ESO value measure the cost to the company.
This cost derives from dilution of existing shareholders’ interest in the firm.
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above reservation level, their motivation to exert effort would be
increased if they felt that the current share price was so far below
exercise price that it was unlikely their ESOs would ever be in the
money.
• Competition for competent employees. To the extent that their
greater is firm risk and resulting share price volatility. Consequently,
repricing becomes a more effective effort motivator as firm risk
increases.
• Extent to which current options are under water. The higher the
excess of exercise price over current share price for currently–
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may increase the incentive of managers to exert longer–run effort,
which could explain the finding of a 5–year improvement in profitability
• Firm risk. The decline in share price leading up to repricing may
indicate an increase in firm risk and resulting increased share price
volatility. The greater the firm’s share price volatility, the greater the
them to perceive that increased effort on their part will lead to share
price increase.
• Other compensation components, such as salary and cash bonuses,
are unlikely to increase when the firm is performing poorly. This may
put a “brake” on effort motivation that cancels any increase in
16. Note: A general point that underlies these hypotheses is that a good performance
measure should be highly informative about the manager’s effort in running the
firm, and thus in generating investor payoff. This is accomplished through an
efficient trade–off between sensitivity and precision.
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horizon.
• To control the manager’s compensation risk. Since ESOs have
relatively low downside risk and considerable upside risk, they
encourage the manager to adopt risky projects. They also help to
offset the downside risk imposed when compensation is based on
(conditionally) conservative net income. Conservative net income
quickly, and managers are free to dispose of shares acquired, ESOs may
induce a short decision horizon, resulting in opportunistic actions such as
pump and dump, manipulation of share price, and other actions discussed in
Section 8.6.
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b. Under the power theory, the CEO has sufficient power to influence the
c. From the market model (Section 4.5.1, Equation 4.4), noting that
αj = Rf (1–βj), the expected return on UnitedHealth’s shares for May 11 was:
d. Reasons why UnitedHealth’s share price fell on May 11:
• The whole market fell, pulling UnitedHealth shares down with it.
However, this contributed to only part of the share price fall.
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e. Under APB 25, an expense had to be recorded for any amounts that ESO
awards are in the money, that is, for the intrinsic value of the ESOs (see Section
8.6). This expense was disguised by the late timing. Correction of the late timing
g. Other ways to manipulate the value of ESO awards:
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18. a. In theory, awarding shares and ESOs as compensation should give
management a longer–run decision horizon, since compensation based on share
performance is less affected than net income–based compensation by actions that
may lower reported earnings in the short run (e.g., R&D) but which promise longer–
term payoffs. A longer–run decision horizon should also discourage the type of
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19. a. If shareholders have information about executive compensation, such as
amounts and types of compensation, they can relate this pay package to share
price performance and can thus make informed decisions on whether the
executives are overpaid in relation to their performance. If they feel these are out of
line, they can bring pressure on the firm to change the compensation contract. This
or manufacturing for stock so as to bury overhead costs in inventory. Managers
who hold company options and/or shares will realize that the market will punish the
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firm’s share price upon becoming aware of such actions, thereby lowering the value
than in offshore, politically unstable, or arctic regions. Such actions are not
necessarily in the best interests of the firm and its (diversified) shareholders.
However, if share–based compensation is in the form of ESOs, which have limited
downside risk, the manager may adopt very risky operating policies, since he/she
has everything to gain and little to lose. Some balance between these two types of
market value (equivalently, the reservation utility he/she can command), reasonably
reflects the manager’s ability.
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The compensation disclosure requirements add to the stock of publicly available
may have enough power in the organization to attain excessive compensation
anyway. Note that the power theory includes tactics whereby the CEO may do this,
namely camouflage to disguise excessive compensation and reduce public
outrage.
A reasonable conclusion is that the disclosure requirements will improve the
working of the managerial labour market, since they increase publicly available
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fundamental value. One reason is that the requirements say nothing about earnings
management—controlling this is the responsibility of the accountant/auditor and
GAAP. The disclosure requirements do include a “detailed explanation” of the
20. a. Whether say on pay is an advantage or disadvantage depends on which
model of executive compensation is most descriptive of reality. If managerial labour
markets are reasonably efficient, managers receive their reservation utility. If so,
any reduction in utility of compensation as compensation committees anticipate or
react to shareholder say on pay concerns may lead to managers leaving the firm or
