Question

If a company’s board of directors wants management to maximize shareholder wealth, should the CEO’s compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock’s intrinsic value? Which would be the better performance measure? Why? (250 words)

Answer 1

If the company’s board of directors wanted the management to maximize shareholder wealth, then the CEO’s compensation should be set based on the growth rate of the Net Income of the company because the CEO can influence the shareholder’s wealth only upto the level of operations or net income.

The main financial objective of the management would be the maximizing the shareholder’s wealth, so all the activities performed by CEO and its management would be to increase the sales and net income. The operating income could be raised either through the increase of gross profit or decrease in administrative expense. So, management could increase the gross profit by increasing the sales or increase the net income through decrease in the expenses.

The performance should be measured through (i) percentage increase in Sales, (ii) percentage decrease of expenses, or (iii) overall percentage increase in net profit of the company.

It would always better to measure the performance of the management through the growth rate in reported profits instead of stock’s intrinsic value because management can only influence the activities upto the operational level and hardly have any control in the financial expenses or matters. The past activities or shares market value should not be allowed to intervene the performance of the management in the current year because it is a part of intrinsic value calculation.