Managerial Compensation is a highly controversial topic in our society today. Some believe that CEO compensation is warranted while others believe that there should be a cap on the level of compensation managers can earn. After reading the section in Chapter 1 on “The Agency Problem and Control of the Corporation,” please weigh in on this debate. Be sure to consider important factors such as agency problems and the concept of maximizing shareholder value. Do these views differ in reference to professional athletes? Please reference your sources.
Chapter 1 section reference:
The Agency Problem and Control of the Corporation
We’ve seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, we’ve also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might management choose to pursue its own goals at the stockholders’ expense? In the following pages, we briefly consider some of the arguments relating to this question.
The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. For example, you might hire someone (an agent) to sell a car you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.
Suppose you hire someone to sell your car and agree to pay that person a flat fee when he or she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to get you thebest price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way in which an agent is compensated is one factor that affects agency problems.
To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to Page 11take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.
More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity, such as the one we have just described.
Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess theaccuracy of financial statement information could be one example.
It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control or, more generally, corporate power or wealth. This goal could lead to an overemphasis on corporate size or growth. For example, cases in which management is accused of overpaying to buy another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit the stockholders of the purchasing company.
Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.
DO MANAGERS ACT IN THE STOCKHOLDERS’ INTERESTS?
Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates, at least in part, to the way managers are compensated. Second, can managers be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that even in the largest firms, management has a significant incentive to act in the interests of stockholders.
Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is this option. In fact, options are often used to motivate employees of all types, not just top managers. For example, in late 2016, Alphabet’s more than 72,000 employees owned enough options to buy 3.3 million shares in the company. Many other corporations, large and small, have adopted similar policies.
The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.
In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, according to Equilar, the best-paid executive in 2016 was Thomas Rutledge, theCEO of Charter Communications, who made about $98 million. By way of comparison, Rutledge made less than performer Katy Perry ($135 million) and way less than boxer Floyd Mayweather ($300 million). Information about executive compensation, along with lots of other information, can be easily found on the web for almost any public company. Our nearby Work the Web box shows you how to get started.
While the appropriate level of executive compensation can be debated, bonuses and other payments made to executives who receive payments due to illegal or unethical behavior are a problem. Recently, “clawbacks” and deferred compensation have been introduced to combat such questionable payments. With a clawback, a bonus can be reclaimed by the company for specific reasons, such as fraud. For example, in 2016, former Wells Fargo CEO John Stumpf was forced to forfeit $41 million and former retail banking head Carrie Tolstedt had to give up $19 million due to behavior while the two led the company. Then, in April 2017, Stumpf was forced to return another $28 million and Tolstedt was forced to return an additional $47.3 million. Page 13The use of deferred compensation has also increased. Deferred compensation is money paid to an executive several years after it is earned. With a deferred compensation agreement, if circumstances warrant, the payment can be canceled.Get Finance homework help today
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