Question

8. Management compensation 

Here are a few questions about compensation schemes that tie top management's compensation to the rate of return earned on the company's common stock.

a. Today's stock price depends on investors' expectations of future performance. What problems does this create?

b. Stock returns depend on factors outside the managers' control-for example, changes in interest rates or prices of raw materials. Could this be a serious problem? If so, can you suggest a partial solution?

c. Compensation schemes that depend on stock returns do not depend on accounting data. Is that an advantage? Why or why not?

Answer 1

a.

If a firm announces the hiring of a new manager who is expected to increase the firm’s value, this information should be immediately reflected in the stock price. If the manager then performs as expected, there should not be much change in the share price since this performance has already been incorporated in the stock value.

b.

This could potentially be a very serious problem since the manager could lose money for reasons out of her control. One solution might be to index the price changes and then compare the actual raw material price paid with the indexed value. Another alternative would be to compare the performance with the performance of competitive firms.

c.

It is not necessarily an advantage to have a compensation scheme tied to stock returns. For example, in addition to the problem of expectations discussed in Part (a), there are numerous factors outside the manager’s control, such as federal monetary policy or new environmental regulations. However, the stock price does tend to increase or decrease depending on whether the firm does or does not exceed the required cost of capital. To this extent, it is a measure of performance.